Monday, November 9, 2009

Reserves Poised to Destroy the Dollar

Our prosperity rests upon cooperation under the division of labor. We all produce just one or a few things, but we produce them in massive quantities. Our productivity rests upon capital accumulation applied to our work. We command the output of others’ work efforts by use of money, the indirect medium of exchange. Without money we would be reduced to a primitive barter economy. Most of us would die. This is the bald fact about the need for a money economy.

The Price Level Determined by the Supply and Demand for Money

How much money is required to purchase the output of society is called the price level, which is determined, in broad terms, by only two things—the quantity of goods available for sale and the quantity of money available for purchasing society’s output. Because we use money as the mechanism for exchanging the goods and services produced in our division of labor society, economists refer to the price level as being determined by the supply and demand for money. But this does not change the nature of the issue. Money merely represents the value the market places upon previously produced goods. Rather than price things in terms of the number of apples an apple grower must exchange in order to purchase his necessities, he uses money. Therefore, its quantity and its demand determine the purchasing power of money.

Say’s Law Explains Purchasing Power

Jean Baptiste Say explained this as clearly as anyone, when he stated that all economic activity tends toward the equilibrium level at which all supply is demanded by purchasers. Most people understand this economic law—Say’s Law—as “supply creates its own demand”. This is merely shorthand for explaining that it is what we produce that becomes the means by which we buy things. Instead of the apple grower exchanging apples for a necessity, he sells his apples for money and then buys his necessities with that money. Money is the intermediate exchange mechanism, but it was his apple production that gave the apple grower purchasing power in the market.

One can now understand the importance of money. Not only do we need something to use for intermediate exchange, but its quantity is critically important too. Expanding the quantity of money provides society with no utility; it merely lowers its purchasing power on the market, disrupting commerce and making it more difficult to plan for our economic future. If we do not know what money will buy in the future—because its supply has been expanded or may be expanded arbitrarily to some unknown level—then investment in long term production processes becomes very risky and we get less of it. And the only way to have more goods available in the future is to expand long term production.

One can see from the above brief discussion of the nature of money as a medium of exchange that it is crucial that the quantity of money remain stable in order for it to provide us with its primary service, which is as a communication mechanism of people’s preferences not only in the near term but also in the future. Unfortunately, it is the quantity of money that is under severe attack today.

Expanding Reserves Means Expanding Money Supply

The quantity of money available in the U.S. is controlled by our central bank, the Federal Reserve Bank (the Fed). Its primary means of control is by manipulating bank reserves, either by changing the ratio of reserves banks must keep at the Fed (increasing the reserve ratio would be deflationary and decreasing the reserve ratio would be inflationary) or by adding to or subtracting from the level of bank reserves. The latter method is the more important of the two. There are several methods that the Fed uses to add to bank reserves--but it is not important to explain HOW the Fed adds reserves as is the fact that the Fed has added MASSIVELY to bank reserves in the past year and continues to add to reserves. The outcome could be catastrophic.

Here are some statistics taken from the Fed’s own website. I will explain their importance further down. All numbers are billions of dollars.

M2 (Cash, checking accounts, savings and money market accounts): $8,333
Total Reserves: $1,122
Required Reserves $62
Excess Reserves $1,060

Notice the level of “excess reserves”. These are reserves of the banks that may be used in the future to increase the money supply. Currently the level of “required reserves” is only $62 billion to support $8,333 billion of the most widely used measure of the money supply--M2. This means that the ratio of reserves to money is only .74%-- less than one percent. Under normal circumstances the amount of excess reserves banks hold is around $2 billion; this small amount relative to our money supply being considered the frictional amount that cannot be utilized in a dynamic banking system. Excess reserves are now a whooping $1,060 billion! Just consider this fact: if a money supply (as defined by M2) of $8,333 billion can be supported by “required reserves” of only $62 billion, then the current level of total reserves--$1,122 billion—will support a money supply of $149,784 billion, eighteen times the current level!

Remember our discussion earlier about how the price level is determined by the quantity of money and the demand for money, where the quantity of money commands all the supply of a society’s output (its “demand”, as we now understand it according to Say’s Law). If the quantity of money can expand by a factor of eighteen, the price level will expand right along with it, because no one expects America’s output--as measured in the number of real things, not its inflated monetary value—to expand by eighteen times its current level. If anything, the environmental movement has brainwashed a large percentage of our citizens to oppose any increase in American production as harmful to Mother Earth. But this is another issue.

End the Fed

Since the establishment of the Fed in 1913, there has been only one prolonged time period in which the banks kept a significant amount of “excess reserves”. You guessed it—the Great Depression years of the 1930s. It is in their nature for banks to expand lending, which concomitantly expands the money supply, until all of the “excess reserves” become part of their “required reserves”. This is how banks expand their business and their profits.

The current very high level of “excess reserves” means that there is no institutional brake upon hyperinflation. The level of bureaucratic irresponsibility at the Fed is bewildering, since the Fed’s primary commission is to safeguard our money. If the Fed bureaucrats have so inflated reserves to the level that our money supply can increase by eighteen times its current level, one is left to conclude either that they are hopelessly incompetent or that there is some malevolent intent to throw the nation, and the world, into chaos. Whatever the reason, we now can see clearly why there is a growing movement in America to “End the Fed”. For so many reasons in addition to the primary one I have discussed here, the Fed has become what President Andrew Jackson called a corrupt institution. Jackson did, in fact, “End the Fed” of his era, the Second Bank of the United States. His was a heroic effort that took both terms of his very popular presidency. Ours is a much more difficult task, since our president shows little understanding of the danger the Fed posses to the American economy and may actually be in favor of taking advantage of the corrupting powers of the Fed, such as the ability of government to spend without taxation or honest borrowing in private financial markets.

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