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Friday, July 20, 2007

Reader Mail #1 - The Federal Reserve Still Sucks

To my complete astonishment, I got an E-Mail from a reader asking a question. I will share his question (paraphrased) and my response here.

Dear FSK,

I've been debating some clueless losers in another forum. They insist that the Federal Reserve is super-awesome and a boon to all mankind. They say that the Federal Reserve is just fixing one tiny thing: the Discount Rate. That's not such a big deal, is it? The Federal Reserve raised interest rates in the past few years. Isn't that proof they're really looking out for the common good?

Can you explain to me again why the Federal Reserve sucks so much?

Wage Slave Trying to Educate Himself

I will share my response with everyone, and not just that one reader.

Even though the Federal Reserve sometimes raises interest rates, the Discount Rate is always lower than what the free-market interest rate would be. The Federal Reserve sometimes increases or decreases the size of the subsidy to the financial industry, but there always is a subsidy.

Currently, growth in M2 is over 6% and interest rates are 5.25%. That is negative real interest rates of around -1%. Some people say that M3, if it were still reported, is growing at 8-10% or more. You can look up the rate of growth in M2 on the Federal Reserve's own website. Those clever crooks at the Federal Reserve stopped publishing M3, because the values published would have been too embarrassing. In case you can't divide on your own, June 2007 M2 is 7245.7, June 2006 M2 is 6826.4, and the rate of growth in M2 is 6.1%.

Under a pure gold standard, real interest rates can never be negative, provided the economy is growing faster than gold is being mined. People would just hold onto their physical gold.

The rate for long-term bonds and mortgages is determined by the average expected future Fed Funds Rate. If people expect the Fed Funds Rate to average 5% over the next 10 years, then the 10 year Treasury bond yield will be 5%. If it was greater, people would borrow at the Fed Funds Rate and buy 10 year bonds. If it was lower, people would short sell Treasury bonds and invest the money at the Fed Funds Rate. Professional traders can make an interest rate swap with very little capital commitment. It's very easy to arbitrage differences between the 10-year Treasury yield rate and the expected future Fed Funds rate.

Mortgage rates are determined similarly. They are priced by the expected future Fed Funds Rate, plus the risk associated with a mortgage.

The Federal Reserve's price-fixing efforts cascade throughout the entire economy. Large corporations can borrow more cheaply than small corporations. The Federal Reserve is, in effect, subsidizing large corporations. With market-determined interest rates, financing growth though earnings would be equally attractive to financing growth via debt. A small business has to grow via reinvested profits, because it can't borrow cheaply. Market-determined interest rates would place small businesses on equal footing with large corporations.

The benefits of the Federal Reserve's subsidy are concentrated in the financial industry. Large corporations also get some benefit, due to their ability to borrow cheap. Hedge funds and leveraged buyout firms are also recipients of a massive government subsidy. They can borrow at slightly more than the Fed Funds Rate. A hedge fund or leveraged buyout firm typically uses a leverage ratio of 7x to 10x. If real interest rates are -3% to -5%, then a profit of 21% to 50% is realized just from the use of leverage.

The Federal Reserve only needs to directly fix the Fed Funds Rate. Then, "market forces" fix prices in the rest of the financial industry and the economy. However, all these other prices are determined by the Federal Reserve's practice of fixing interest rates.

The bottom line is:

Interest rates should be determined by the free market, just like the price of everything else.

Whenever the government fixes prices, it causes damage.

The interest rate that maximizes the growth in the economy is the free market interest rate. Artificially low interest rates encourage wasteful spending on things that aren't economically worth it.

I addressed most of these points already in my blog:

The Federal Reserve and Income Tax Conspiracy Theory

The Communist Manifesto's Successful Implementation in the USA

The True Purpose of the Income Tax

The True Purpose of the Federal Reserve

The Compound Interest Paradox

I like my post on "The Compound Interest Paradox". It shows the fundamental structural flaw in debt-based money. With debt-based money, debts always grow exponentially faster than the money supply. The only possible outcome can be that everyone is enslaved under a crushing debt burden.

I have come to the conclusion that lobbying the government for monetary reform is pointless. There are too many people that benefit from the current flawed monetary system. The only solution is to start over with a new monetary system.

Let me know if you have any other questions. You can post a comment or E-Mail me. My E-Mail address is


Anonymous said...


I looked at the Federal Reserve Banks Combined Financial Statements, and I see an entry for about $30 billion/year under "Payments to U.S. Treasury as interest on Federal Reserve notes". Is this different than the interest paid on prime rate loans?
Randy Lee

FSK said...

They are completely unrelated.

The interest charged by someone who borrows at the Prime Rate is typically the Fed Funds Rate plus a spread, currently 3%. This "spread" of 3% is pure profit for the financial industry. They borrow from the Federal Reserve at 5.25% and loan out at 8.25%. It's pure "Illicit Interest Arbitrage". A profit of 3% is made, but no work is performed.

Notice that the Prime Rate of 8.25% is much closer to the true inflation rate of 5.25%. Also notice that many large corporations can borrow as low as 6%, through bond offerings. The Prime Rate of 8.25% is charged to retail customers and small businesses. Large corporations get to borrow much cheaper than individuals and small businesses. There's a huge government subsidy to the financial industry and large corporations, paid by everyone else as inflation.

In a fairer market, individuals should be able to borrow directly from the Federal Reserve at 5.25%. Why should borrowers have to go through the middlemen of a bank and pay an extra 3%? (Of course, in a truly free market, there would be no Federal Reserve, nor any government at all.)

That's the problem with the US economy. The middleman always gets his cut, even though he does no real work.

When the Federal Reserve "monetizes the debt", it creates new money to repurchase Treasury notes that are nearly expired. This allows the Federal Reserve to keep interest rates at an artificially low level without doing any work. The Federal Reserve buys back Treasury notes, but it creates the money used to buy back the notes.

For example, the Federal Reserve buys back Treasury Notes with a face amount of $1B. They are nearly expired, so their market value is $999M. The Federal Reserve creates a debit of $999M in its own account, and a credit of $999M in the account of whoever sold the Treasury note, typically a bank. That is $999M of new money. Fractional Reserve Banking causes that $999M to be multiplied by the reserve ratio, say 10x, to $9.99B in new money.

A few days later, the Treasury note expires. The Treasury note is redeemed with the government for its face amount, $1B. The $999M debit in the Federal Reserve's account cancels out, leaving a credit of $1M. The Federal Reserve did no work when it purchased the bond. It created the money it used to buy back the Treasury note. The Federal Reserve has no cost of capital. The Federal Reserve made a riskless profit of $1M. As long as interest rates are positive, the Federal Reserve can make a riskless profit.

After using this riskless profit to pay its expenses, the balance must be returned to the Federal government. However, the Federal Reserve's open market transactions have never been audited. It could use tricks to inflate or deflate its earnings. For example, instead of printing $999M to buy the Treasury note, it could buy the Treasury note directly with cash on hand. That would deflate its apparent earnings.

The budget item "Payments to U.S. Treasury" is the surplus interest income being returned to the U.S. Treasury. However, the open market transactions themselves are not audited. Only the total profit is reported.

The point is not the Federal Reserve's earnings. The point is the massive subsidy to the financial industry in the form of lower interest rates. If the Federal Reserve let the free market determine the interest rate, interest rates would be 8-10% or higher. Then, the banks would have to charge 11% or more as the "prime rate". That would make borrowing unattractive.

A prime rate of 8.25% is probably lower than inflation, so it still makes sense to borrow at 8.25%. However, large corporations can borrow at only 6%, giving them a huge advantage over small businesses or individuals.

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