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Saturday, September 1, 2007

Federal Reserve Thoughts - Answers to Media Myths

I originally wrote this article for the Ron Paul wiki, and I broke it up into several pieces and copied it here.

There are a lot of false ideas circulating about the Federal Reserve. Whenever I try talking to someone about the Federal Reserve, they start talking incoherent nonsense. I view that as a symptom of a very successful media campaign to keep people ignorant.

There are a lot of "debunk the critics of the Federal Reserve" websites. I read some of them, and they seemed like complete nonsense to me. Let me know if any of them makes an argument that I didn't properly address.

Making the Federal Reserve Politically Independent is Good

Why should the central bank, which exerts enormous influence over the economy, be completely shielded from political and economic pressure?

The Federal Reserve was made independent because previous central banks were successfully halted by a President who figured out what was going on.

Deflation is Bad, Inflation is Good

Inflation is great for someone who has borrowed money. It means that it is easier for them to repay their loans. Since the Federal Reserve's goal is artificially low interest rates to encourage borrowing, the Federal Reserve likes inflation.

If you've borrowed money, deflation is lousy. It makes it harder to repay a loan. Deflation is a disincentive to borrowing. The Federal Reserve hates deflation because it wants to encourage people to borrow money.

With a fixed money supply, deflation naturally occurs over time as the economy becomes more efficient. With a fixed money supply, as the size of the economy grows, prices decrease. Under a gold standard, the money supply is necessarily fixed, because there's only a certain amount of physical gold. However, even a gold standard is subject to manipulation, due to fractional reserve banking and the importing/exporting of gold.

Even with a gold standard and unregulated fractional reserve banking, prices should decrease over time. Honest fractional reserve banking legitimately expands the money supply to match the supply of the economy. If all fractional reserve loans are backed by actual goods and services, then fractional reserve banking is honest. Prices still will decrease over time, due to productivity gains. The value of an ounce of gold, or a trusted paper promise to pay gold, should be mostly constant.

Inflation is great if you're a debtor. Inflation is lousy if you're a bondholder or holding cash. The average American typically holds bonds or cash. The average American has benefits not properly indexed to inflation, such as Social Security or pensions. The Federal Reserve is not looking out for the interests of average Americans; it's looking out for the interests of the financial industry.

There is nothing intrinsically wrong with deflation. You should expect prices to decrease as the economy becomes more efficient. The only reason deflation is bad is because money is only created via debt. With deflation, people would make fewer loans, and the supply of money would shrink, causing even more deflation.

One of the arguments against deflation is that workers like receiving pay raises. Workers like getting a 3% annual raise. They don't notice that inflation really is 8-10%. With a fixed money supply, prices decrease as the economy grows. This also means that, in times of rapid economic growth, salaries would also have to decrease. That should be acceptable to workers, because the price decreases would be greater than their salary decreases. However, workers tend to resist salary decreases. Inflation is a way to cut salaries without workers noticing and protesting.

That's the reason the average person doesn't benefit from importing cheap labor or exporting jobs to third world countries. If the money supply was fixed, the decrease in prices due to cheaper labor would be more than the decrease in wages. However, the average person does not benefit because the price decrease was stolen via inflation. Inflation allows the financial industry to steal all the benefits of importing cheap labor or sending jobs to other countries. The idea that immigration is bad or exporting jobs is bad is a smokescreen. It is only bad because the efficiency gains are stolen by the financial industry via inflation. People are trained to blame the cheap imported labor or the companies that export jobs. The real blame belongs to the Federal Reserve for inflating the money supply and giving the benefits of increased productivity to the financial industry.

The Federal Reserve is not Foreign Owned

The actual ownership of the Federal Reserve is not public, so how can this be verified?

The Federal Reserve is probably mostly owned by US corporations, but many of these corporations have substantial foreign ownership. With anonymous corporate ownership, how can you verify who controls the corporations that control the Federal Reserve?

The Federal Reserve is Controlled by the Board of Governors

The actual people who work at the Federal Reserve are nominated by the private banks who own it. The Board of Governors merely gets a yes/no vote on the nominees. It's like saying the Congress gets to choose the Supreme Court. Congress merely gets to accept or reject the President's nomination.

Also, the Open Market Committee is separate from the Board of Governors. The Open Market Committee has the real power, because it sets the interest rate target. The Open Market Committee is appointed by the private corporations that own the Federal Reserve.

Further, when the President selects a nominee for the Board of Governors, he chooses from a list provided by the financial industry insiders.

The Federal Reserve is Audited

The Federal Reserve's open market transactions are not audited. The Federal Reserve claims that the records of its open market transactions are immune from the Freedom of Information Act. There have been superficial audits. There has not been a deep audit that looked at every single open market transaction.

The real abuse of power by the Federal Reserve is its open market transactions, the very thing it refuses to release to the public.

The Federal Reserve Returns its Earnings to the Treasury

The Federal Reserve's open market transactions have not been audited, so how could anyone know what its true earnings are? The Federal Reserve could use tricks to deflate its earnings.

Besides, the real point is the subsidy to the financial industry due to artificially low interest rates. This would not show up as earnings by the Federal Reserve.

Congress is Responsible for the National Debt, not the Federal Reserve

The Federal Reserve guarantees that the total debt of society can only increase over time, due to the Compound Interest Paradox. As the Great Depression showed, a national debt is necessary to allow private citizens to have any money at all. Money in one person's pocket must necessarily be offset by a greater debt by someone else.

While Bill Clinton was President, the amount of private debt increased substantially. That is the reason the government was able to have a budget surplus during that time. Also, the Soviet Union fell at that time, which meant that a lot of dollars were imported into the former Soviet countries. The people there trusted dollars more than their own government's money. A lot of dollars were soaked up by this new market, which caused deflation in the US.

Here is the real reason why the national debt is a "big deal". Only a certain amount of inflation can occur before the average person would get wise to the flaws in the monetary system. Think of the inflation revenue as a pie shared by the financial industry and the government. When the federal government has a budget deficit, it's claiming a larger share of the inflation revenue pie. This decreases the amount of inflation revenue available to the financial industry.

When the federal government has a balanced budget, that means that the financial industry gets to claim all of the inflation revenue for itself.

If the growth in the money supply was equal to the GNP growth rate, then the inflation rate would be zero. In other words, a growing economy allows a certain amount of inflation to go undetected. The benefits of a growing economy belong to the government and the people, not to the financial industry.

Printing Money to Pay off the National Debt would be Inflationary

When the government has $1 billion of deficit spending, that causes $1 billion of inflation. It does not matter that the government also issued an IOU that it will repay the money. Whether the government carries the debt on its books, or prints the money and pays off the debt, makes no difference at all. The inflation was caused when the money was spent.

If the government runs a surplus later to pay off its debt, then it is causing deflation later. A government deficit is inflationary; a surplus is deflationary. A government can't "store money" by having a surplus, because fiat money is inherently worthless.

If the inflation rate is higher than the rate the government pays on its debt, and I suspect it is, then the government is actually making a profit due to its deficit. If inflation is really 10% and government bonds pay 5%, then holders of government bonds are earning a real return of -5%. Why does anyone own government bonds at all then? The Federal Reserve is expected to continue fixing interest rates in the future. If you expect the short-term interest rates to average 4.75% over the next 10 years, then you can make a sure profit by borrowing and buying a Treasury bond that yields 4.8%. Interest rate swaps can be made with very little capital commitment. It's cheap to conduct arbitrage between the 10 year bond yield rate and the expected average future Fed Funds Rate.

The government is not subject to the same accounting rules as everyone else. If I am in debt $100,000 and default, then the person I owe the money to is stuck. If the government is in debt $1 billion, then the debt is collectively paid by everyone else as inflation.

The point is that a government can have unlimited debt in the currency it controls. If the US government had debts denominated in Euros, then the US government could theoretically be bankrupted. That's what happens to third world countries. They have debts in dollars, but their income is in their local currency. Under such a scenario, a collapse in hyperinflation is possible because the Compound Interest Paradox makes it hard for the small country to come up with dollars to repay its dollar-denominated debt. As long as the US government has debts that are only in dollars, a monetary hyperinflation collapse is less likely.

Suppose the government minted a $100 trillion coin, deposited it in its account at the Federal Reserve, and received a $100 trillion credit. Would it effect the economy at all? No, it would not matter unless the government actually spent the money. As the money was spent, everyone else would experience inflation.

If the government printed money and paid off its debts, it would not be inflationary. However, it would cause market interest rates to rise. This would be contrary to the Federal Reserve's goal of artificially low interest rates. That's the reason the government can't be allowed to directly print and spend money.

Suppose there was $1 trillion in circulation. The government wants $10 billion of deficit spending. It prints an IOU for $10 billion and sells the bond for $10 billion. (To keep things simple, ignore the effect of interest here.) The government spends the $10 billion. Now, there is $1 trillion cash in circulation, plus a $10 billion bond. However, the person holding the $10 billion bond can sell it for $10 billion cash whenever he wants to. If he wants to buy something that costs $10 billion, he'll sell the bond, take the cash raised, and buy it. In other words, there is $1.01 trillion in circulation now, because the bond is as good as cash. The government's $10 billion in deficit spending wasn't free. Everyone else experienced 1% inflation.

In the above example, suppose the government just printed the $10 billion and spent it. Now, there would be $1.01 trillion in circulation. However, there is a fractional reserve banking system and government-subsidized artificially low interest rates. That extra $10 billion can be multiplied via fractional reserve banking to $100 billion. The government caused 1% inflation when it spent the $10 billion, but the banking system caused an additional $90 billion of inflation. Government bonds don't count as reserves for the purpose of fractional reserve banking, so that's why it's preferable for the government to issue debt rather than spending money directly into circulation.

The real reason why the government can't be allowed to spend money into circulation is the fractional reserve banking system combined with government-subsidized low interest rates. Artificially low interest rates guarantee that banks will be able to loan out any new money that was printed. Fractional reserve banking allows banks to create addition inflation on top of the inflation the government caused by its deficit spending.

If the government directly printed and spent money into circulation, the Federal Reserve, to contain inflation, would have to do the opposite of what it normally does. Normally, the Federal Reserve prints money, buys bonds, and redeems them with the government, making a riskless profit. With extra money in circulation, the Federal Reserve would have to sell short bonds to soak up the extra money supply. The Federal Reserve can't make a guaranteed riskless profit when it does that.

President Kennedy Issuing Silver Certificates had Nothing to do With the Federal Reserve

President Kennedy's attempt to issue money competing with the Federal Reserve was an attempt to abolish it. The Federal Reserve acts to keep interest rates artificially low. Issuing new money causes interest rates to rise. For the President to be issuing money separate from the Federal Reserve would be like stepping on the accelerator and brake pedal simultaneously. The Federal Reserve would be acting to keep interest rates low, and the President would be acting to keep interest rates high.

If President Kennedy's silver certificates were so unimportant, why were they removed from circulation immediately after he was killed?

Also, the President wouldn't need to issue money backed by something. All he needs to do is write "this note is legal tender" and they would be as valid as the Federal Reserve notes. From the point of view of an American citizen, the Federal Reserve notes were fiat money when Kennedy was president because a US citizen could not redeem them for gold.

The Federal Reserve Doesn't Cost the Government Money

The Federal Reserve costs the government all the money that is rightfully the government's due to seignorage. The Federal Reserve steals all seignorage income from the government and transfers it to the financial industry.

When the money supply is diluted via inflation, that money is rightfully the government's. Currently, the benefits of diluting the money supply accrue primarily to the financial industry.

A Bank has a Limited Ability to Create Money Based on its Reserves

A bank that has greater loan demand than deposits can always borrow money other banks or from the Federal Reserve at the Fed Funds rate. That is the whole point of the Federal Reserve's open market operations. Overall, the Federal Reserve acts to increase bank reserves rather than decrease them.

A bank's ability to write loans is completely decoupled from the amount of customer deposits it has. A bank can always borrow to get more reserves.

The Federal Reserve Smooths Out the Business Cycle

The Federal Reserve is the cause of the business cycle.

There were business cycles before the Federal Reserve, but that was because banks were colluding to simultaneously stop issuing loans. They created business cycles to benefit themselves.

The large international banks artificially created economic cycles. They manipulated the money supply to bankrupt their smaller competitors. They used this artificially created economic chaos to get the Federal Reserve passed.

One way to completely smooth out business cycles is to outlaw money creation via debt. Only the government should be allowed to create money, either by directly spending it or creating it via a loan. If only the government could create money via debt, then the government would know the exact money supply at all times. If the government directly created money via debt, and simultaneously created and spent the required interest payments, there would be no Compound Interest Paradox.

Another way to eliminate business cycles is to eliminate government. There are no business cycles in a truly free market. Business cycles are an artificial creation of a coercive government. Business cycles are a tool for confiscating wealth.

The Federal Reserve Prevents Banks from Failing and Protects Customer Deposits

The highest rate of bank failures in US history was between 1913 and 1934, immediately after the Federal Reserve was formed. The banks who were not cartel insiders were forced into bankruptcy, because they could not anticipate when interest rates would be raised or lowered.

The Federal Reserve stole all gold held by private citizens. The Federal Reserve forced the US off the gold standard and forced President Roosevelt to confiscate the gold of all private citizens.

The Federal Reserve Stimulates the Economy

The Federal Reserve intentionally slows economic growth. It specifically says that it is raising interest rates to slow economic growth, worried about excessive inflation.

The money supply keeps expanding and contracting due to the Compound Interest Paradox. There is no way to keep the economy stable with a fixed interest rate.

The interest rate that maximizes economic growth would be the interest rate determined by the free market. Artificially low interest rates cause wasteful spending. This wasteful spending slows economic growth because everyone else pays the cost of inflation.

For example, suppose I'm saving up to buy a car that costs $20,000. While I'm saving, inflation drives the price of the car up to $22,000. The interest I received in the meantime was insufficient compensation for inflation. It takes me longer to save enough money to buy the car, and as a result fewer cars are sold.

Further, the Federal Reserve's policies guarantee that the total productive capacity of the economy is always greater than the aggregate purchasing power. Artificially low interest rates encourage borrowing and an increase in productive capacity. However, the money to pay interest on those loans is not simultaneously created. Productive capacity grows faster than purchasing power. During a boom cycle, a corporation is deluded into expanding due to cheap loans. During the bust cycle, the corporation finds that there isn't enough money in circulation for customers to buy its products. The corporation might be forced into bankruptcy. In bankruptcy, its creditors (banks) convert the debt into equity. Essentially, the banks created money via debt, and then converted that debt into a tangible asset.

The banks hold onto the confiscated property during the bust cycle. During the next boom cycle, the banks sell the confiscated property back to the public at inflated prices. During the boom phase of the bust cycle, banks get first dibs on the newly printed money. During the bust cycle, banks confiscate property; banks sell this confiscated property during the next boom cycle at inflated prices.

Artificially low interest rates encourage developing productive capacity that isn't economically worth it. With artificially low interest rates, there isn't enough money in circulation to buy all goods produced. Similarly, with artificially high interest rates, there would be a deficit of productive capacity. Only with a market rate will productive capacity equal purchasing power.

The Federal Reserve Only Holds 7-10% of the National Debt

At any given time, the Federal Reserve owns around 10% of the national debt. The reserve ratio is 10x. The Federal Reserve only needs to purchase around 10% of the national debt. This creates enough reserves in banks to purchase the other 90% of the national debt.

The Compound Interest Paradox is an Illusion, Because Debt Hasn't Grown that Fast

The actual rate of growth in debt is less than what the Compound Interest Paradox predicts because bankruptcies occur. In a bankruptcy, debt is converted into equity, and some debt is forgiven. As long as the total amount of bankruptcies is not too big, banks can absorb the occasional loss. If the Federal Reserve mismanaged its interest rate manipulations, there would be a deflationary depression. If enough bankruptcies occurred simultaneously, banks would not be able absorb the losses of all the bankruptcies simultaneously.

As the ratio of debt to money supply increases exponentially, the Federal Reserve might be forced to walk a tighter and tighter line. Setting interest rates too low would trigger hyperinflation, which would bring down the whole system. Setting interest rates too high would trigger a deflationary depression, which would bring down the whole system as large banks started failing (think Long-Term Captial Management, but on a larger scale). I think that the range of "safe" interest rates is growing smaller all the time.

The Federal Reserve's scam is nearing its end. The laws of supply and demand cannot be tricked forever.

1 comment:

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