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The Fed's own monetary statistics reveal a decade of fiat money inflation and Fed irresponsibility.
In ten years M1, the narrower definition of money, expanded by one half.
M2, the broader definition of money, expanded by 80%.
Bank REQUIRED reserves expanded by 70 percent.
TOTAL bank reserves expanded by 2,600 percent.
EXCESS reserves expanded by 18,500 percent!
Banks have an incentive to expand lending to the maximum extent possible. The only institutional restraint upon bank lending is their reserve requirement. If the banks utilized their excess reserves efficiently over time (as they have in every year except the years of the Great Depression of the 1930s), we can calculate the level that M1 and M2 could reach if the January 2010 ratio of reserves to those two money aggregates remained operative:
M1--$31,436 billion (the current level of M1 is $1,676 billion)
M2--$159,729 billion (the current level of M2 is $8,463 billion)
In other words, it is possible for M1 and M2 to expand by a factor of 18 times their current size. This is a prescription for hyperinflation. It is the hubris of the Fed that it can withdraw excess reserves once it sees prices moving higher. This is not correct. If the Fed were to withdraw reserves in sufficient amounts to forestall higher prices, it would have to send the economy into a true depression, allowing banks and their customers to go bankrupt. The only restraint upon the banking system right now is the lack of capital, the paucity of good loans, and the determination of bank regulators to prevent another fiat money induced economic bubble.
Sunday, February 28, 2010
Saturday, February 20, 2010
The Irresistible Sirens' Song of Inflation
In The Odyssey, Homer’s second epic poem of the Trojan War (The Iliad was the first), Greek hero Odysseus, sacker of Troy, must endure many challenges before he can return to his homeland. Some challenges were new and unexpected, but, as an experienced sailor, Odysseus was aware of the terrible Sirens. The Sirens were beautiful young women who sang irresistible songs that lured sailors to their deaths on rocky shoals. Odysseus wanted to hear the Sirens’ songs, yet he knew the danger. So he ordered his men to fill their ears with wax, to prevent them from hearing the Sirens, and then to tie him to the ship’s mast and not release him under any circumstances. As the ship approached the danger area, Odysseus heard the Sirens’ songs and begged his crew to untie him so that he could follow the Sirens. But, his crew ignored Odysseus and the ship passed the danger. Odysseus had heard the irresistible songs and understood that no man, not even a heroic and disciplined warrior, could refuse the temptation of the Sirens.
Homer’s epics can be understood at many levels, and I choose to interpret the story of the Sirens’ songs as a warning of man’s inherent weakness. There are some temptations so compelling that man must not allow himself to be placed in circumstances where he may succumb. Even when the temptations are known and understood, he must scrupulously avoid coming into contact with them. Powerful men are especially prone to these temptations, feeling superior to other men and certain that they can avoid the penalties involved. As such, they behave recklessly, only to discover that they are as human and as weak as anyone. The fall from grace of Tiger Woods comes to mind.
The temptation of inflation is inherent in our fractional reserve, central banking system in which fiat money is forced upon the populace by legal tender laws. This system creates a central bank lender of last resort—our Federal Reserve Bank—that manufactures money out of thin air, just as would any counterfeiter. But our Federal Reserve has even more power than a counterfeiter, because it operates not in the shadows and outside the law but in full daylight and with all the instruments of compulsion of the modern nation-state. No one may refuse to use its money and no one may use any other. Its only restraint is that imposed by the conscience of the men who are temporarily in charge of its machinery. This is indeed a powerful Siren song to inflate; that is, to print money.
The first temptation is so shower the banking system with money so as to ignite an unsustainable boom. Few chairmen of the Federal Reserve have been able to withstand this temptation. Even Allen Greenspan, who considered himself a “hard money man”, chose to bask in the adulation of the nation during the short-lived Boom years; therefore, he printed money to ignite one Boom after another. His successor, Ben Bernanke, has proven to be just as weak. But the Sirens’ songs are more compelling than merely desiring the limelight, as Ben Bernanke will attest, for he has given us an example of the ultimate irresistible temptation to destruction. Even when it is clear that inflation of the money supply has caused the Boom to turn, inevitably, to Bust, the Fed chairman is compelled to inflate even more. Here is why.
The essence of our fractional reserve banking system is the Fed’s ability to ignite a Boom through an increase in bank reserves. The Fed uses its power to buy assets, usually treasury bonds, to give the banking system additional reserves. The money that the Fed uses to buy these assets is created out of thin air. But that is just the tip of the pyramid, so to speak. As the banks lend money they create money out of thin air—the proceeds of bank loans become checking account money. This money was also created out of thin air, but in many multiples of the reserves that the Fed created out of thin air. Therefore, and this is crucial, this new money is backed by nothing more than debt—the debt of the banks’ borrowers.
As the Boom turns to Bust, due to the lack of real capital made available from real savings rather than money creation, the loans become worthless and, more importantly, the money supported by those loans vanishes. Now the central bank, the lender of last resort, hears the irresistible Sirens’ songs for even more money creation. All segments of society call upon the Fed to bail out the banks’ depositors, most of who are innocent bystanders of this Boom/Bust drive-by shooting. Who can resist the demands of the bankers, their shareholders, and their customers to create even more money so that the banks can honor their depositors’ checks? Everyone, from the president of the United States to the most modest widowed retiree, will ask if this entity called the central bank, formed with the ability to manufacture as much money as it itself deems necessary for the smooth functioning of the economy, is to stand idly by and watch innocent depositors lose everything. Everyone will question the justice of such an act.
Does there exist any person who, as chairman of the Federal Reserve, would be able to live peacefully among his fellow Americans who believed that their plight could be alleviated by his order? Grandma’s checking account must be made secure, at least in nominal dollar terms, from whatever size loan is required from the Fed to Grandma’s bank, regardless of the bank’s ability to repay the loan. Even though we know that the money for this loan is manufactured out of thin air, exactly the same as the money that kicked off the unsustainable Boom, we do not care. The consequences of another irresponsible act must be ignored, just as the original irresponsible act—the printing of money out of thin air—was ignored. Only now the Sirens’ song is even greater.
So, we sail toward the rocky shoals of national bankruptcy in full knowledge that we do so out of an irresistible compulsion. Better to have never heard the Sirens’ song of inflation in the first place. Better to never have given up sound money—gold and silver—in the first place. Better to never have given up responsible banking—one hundred percent reserves--in the first place. Better to never have trusted the weakness of man to withstand the irresistible Sirens’ song of inflation that appears destined to destroy modern economies everywhere in the world.
Homer’s epics can be understood at many levels, and I choose to interpret the story of the Sirens’ songs as a warning of man’s inherent weakness. There are some temptations so compelling that man must not allow himself to be placed in circumstances where he may succumb. Even when the temptations are known and understood, he must scrupulously avoid coming into contact with them. Powerful men are especially prone to these temptations, feeling superior to other men and certain that they can avoid the penalties involved. As such, they behave recklessly, only to discover that they are as human and as weak as anyone. The fall from grace of Tiger Woods comes to mind.
The temptation of inflation is inherent in our fractional reserve, central banking system in which fiat money is forced upon the populace by legal tender laws. This system creates a central bank lender of last resort—our Federal Reserve Bank—that manufactures money out of thin air, just as would any counterfeiter. But our Federal Reserve has even more power than a counterfeiter, because it operates not in the shadows and outside the law but in full daylight and with all the instruments of compulsion of the modern nation-state. No one may refuse to use its money and no one may use any other. Its only restraint is that imposed by the conscience of the men who are temporarily in charge of its machinery. This is indeed a powerful Siren song to inflate; that is, to print money.
The first temptation is so shower the banking system with money so as to ignite an unsustainable boom. Few chairmen of the Federal Reserve have been able to withstand this temptation. Even Allen Greenspan, who considered himself a “hard money man”, chose to bask in the adulation of the nation during the short-lived Boom years; therefore, he printed money to ignite one Boom after another. His successor, Ben Bernanke, has proven to be just as weak. But the Sirens’ songs are more compelling than merely desiring the limelight, as Ben Bernanke will attest, for he has given us an example of the ultimate irresistible temptation to destruction. Even when it is clear that inflation of the money supply has caused the Boom to turn, inevitably, to Bust, the Fed chairman is compelled to inflate even more. Here is why.
The essence of our fractional reserve banking system is the Fed’s ability to ignite a Boom through an increase in bank reserves. The Fed uses its power to buy assets, usually treasury bonds, to give the banking system additional reserves. The money that the Fed uses to buy these assets is created out of thin air. But that is just the tip of the pyramid, so to speak. As the banks lend money they create money out of thin air—the proceeds of bank loans become checking account money. This money was also created out of thin air, but in many multiples of the reserves that the Fed created out of thin air. Therefore, and this is crucial, this new money is backed by nothing more than debt—the debt of the banks’ borrowers.
As the Boom turns to Bust, due to the lack of real capital made available from real savings rather than money creation, the loans become worthless and, more importantly, the money supported by those loans vanishes. Now the central bank, the lender of last resort, hears the irresistible Sirens’ songs for even more money creation. All segments of society call upon the Fed to bail out the banks’ depositors, most of who are innocent bystanders of this Boom/Bust drive-by shooting. Who can resist the demands of the bankers, their shareholders, and their customers to create even more money so that the banks can honor their depositors’ checks? Everyone, from the president of the United States to the most modest widowed retiree, will ask if this entity called the central bank, formed with the ability to manufacture as much money as it itself deems necessary for the smooth functioning of the economy, is to stand idly by and watch innocent depositors lose everything. Everyone will question the justice of such an act.
Does there exist any person who, as chairman of the Federal Reserve, would be able to live peacefully among his fellow Americans who believed that their plight could be alleviated by his order? Grandma’s checking account must be made secure, at least in nominal dollar terms, from whatever size loan is required from the Fed to Grandma’s bank, regardless of the bank’s ability to repay the loan. Even though we know that the money for this loan is manufactured out of thin air, exactly the same as the money that kicked off the unsustainable Boom, we do not care. The consequences of another irresponsible act must be ignored, just as the original irresponsible act—the printing of money out of thin air—was ignored. Only now the Sirens’ song is even greater.
So, we sail toward the rocky shoals of national bankruptcy in full knowledge that we do so out of an irresistible compulsion. Better to have never heard the Sirens’ song of inflation in the first place. Better to never have given up sound money—gold and silver—in the first place. Better to never have given up responsible banking—one hundred percent reserves--in the first place. Better to never have trusted the weakness of man to withstand the irresistible Sirens’ song of inflation that appears destined to destroy modern economies everywhere in the world.
Monday, February 8, 2010
Deadly Duo: Fiat Money and Fractional Reserve Banking
The government propaganda machine is in full swing. It denounces bankers for making bad loans. It proposes more numerous and more onerous regulations in addition to increasing the bureaucracy to implement them. The message is that the free enterprise banking system itself is to blame, that without government regulation there is nothing to prevent bankers from looting their depositors’ money in order to line their own pockets. Bankers make loans that they KNOW will not be repaid and cannot be repaid, all the while paying themselves enormous salaries and bonuses. When the house of cards comes crashing down, the bankers give the bill to the government and the taxpayers.
All the above is a lie.
The fact is that this current crisis, as with all previous crises in the past one hundred years, was caused by government interference in the financial markets. Specifically it is government’s creation of fiat money-- money backed by no commodity; that is, nothing of intrinsic value—that is primarily responsible for our economic problems. This money has two sources—the Fed’s printing press and bank credit expansion. This “deadly duo” touches off the boom/bust business cycle. This business cycle is not something inherent in capitalism. A commodity based money and a legal prohibition against bank credit expansion will end these vicious, wealth destroying and, ultimately, liberty destroying economic crises.
Money is as much a moral as an economic good. Real money is part and parcel of the market economy. It originates as a widely accepted commodity that comes to be used, through the market process, as indirect exchange. As such, its value increases beyond demand for its intrinsic use to include a new demand as something to be exchanged later for some other good. Thusly, real money facilitates the exchange of “something for something”. This is its moral component. But fiat money—that is, money manufactured by the government and backed by nothing—always enters the monetary system as a counterfeit “something for nothing”. There are two corrupt sources of this counterfeit evil.
The first evil source is Federal Reserve monetization of the government’s debt, meaning that the Fed buys government bonds with money that it creates out of thin air. Government itself benefits directly, when, for example, it pays bureaucratic salaries, buys goods and services, and when it rewards its constituents, such as political contributors and voters, through earmarked targeted spending. The first recipients of this new money can purchase goods at the current lower price. Subsequent recipients pay higher prices, because the supply of money increased and pushed up the price level.
Furthermore, this money creates even more money via the “fractional reserve” banking system. Recipients of government spending deposit the checks into their bank accounts; then their banks deposit the checks with the Fed. Bank reserves increase, and banks are allowed to pyramid around ten times the amount of the new and excessive reserves into new loans. These new loans are matched, dollar for dollar, with an increase in the money supply, because banks lend money by crediting the borrower’s checking account. The borrowers spend the money, of course—that is why they borrowed it in the first place. Thusly, bank credit expansion creates new money based upon DEBT. We shall see shortly how fragile this system can be.
Thus far, bank credit expansion has triggered a boom. New projects are started, because the increased quantity of money lowers the interest rate, making long term projects—those for which the cost of funds is most important—now appear to be feasible. Factories expand, mines open, etc., all of which may take years before bearing any real fruit. The problem is that the consumer has not changed his spending habits. He has NOT decided to save more. He purchases immediate, consumer-type goods in the same relationship to his savings as before. In fact the boom may prompt him actually to increase his consumption-to-savings ratio. Therefore, there is no new capital for the successful and profitable completion of these longer-term projects, so these “malinvestments” must be abandoned. Since the projects are abandoned, they never generate revenue for paying off their bank loans. As loans default, the money supply drops, because a large component of the malinvestment was funded by loan generation--when the loans fail, the money disappears.
Now the banks are in trouble. Their capital is reduced dollar for dollar by the loan defaults. It is foolish to ask them to resume lending, because their capital-to-asset ratio is so low. They must build capital before they can begin lending again. But this is not the worst consequence of building the money supply out of debt. The reduction of the money supply reduces overall spending in the economy. This impacts even businesses that did not expand and that previously were healthy and profitable. Their revenue decreases too, driving them to unprofitability. The total amount of goods and services in the economy cannot be sold with this lower volume of spending UNLESS PRICES DROP. Therefore, it is crucial that government do nothing to prevent prices, including the price of labor, from falling. Only a lower price level can bring the economy’s supply of goods and services into equilibrium with less money. As Professor George Reisman of Pepperdine University has explained, falling prices are the antidote to deflation (where “deflation” is defined as a fall in the supply of money).
Perversely, the government recently raised the minimum wage and gave Fannie Mae and Freddie Mac its UNLIMITED guarantee!
Government’s current attempts to prop up prices are doomed to failure. Supply can clear only at lower prices. The malinvestment, especially in housing, must be allowed to liquidate on as good terms as current owners, mostly developers, can get. There is an excessive supply of housing in the economy in relation to other necessary goods. Reports of government efforts to “revive housing” are indications that government is thwarting the necessary correction via its many bailout programs. A more encouraging report would be that the price of housing is falling precipitously. This would be welcome news to all seeking housing—don’t we all love a sale?
We are doomed to repeat these boom and bust cycles, probably with even greater intensity due to government’s foolish interventions, as long as government can print money out of thin air and banks can create even more money out of debt. No regulations can prevent this cycle. In fact some government agencies, such as Fannie Mae and Freddie Mac, are trying to rekindle the boom while other government agencies, such as bank regulators, claim that they can so regulate bank lending to prevent any future malinvestment. This is impossible. The problem lies in the very nature of the monetary system, which sends false signals to bankers and bank regulators alike, inducing them to fuel another unsustainable boom. Money is lent on the cheap to precipitate projects for which no real new capital exists. This money built on debt will vanish as it has in the past, wiping out the hopes and dreams of tens of millions. The lower quantity of money means that total spending will be inadequate to clear the production side of the economy at current, boom-induced high prices. Yet, even though lower prices are the only cure, government and organized labor fight this cure tooth and nail.
The answer lies in driving a stake through the heart of this deadly duo. First of all, return to commodity money, most likely gold. Gold money can be neither created nor destroyed. Once brought into circulation, gold money remains in circulation. Total spending remains the same; only prices change—usually downward, based upon productivity gains—very gradually over time. Next, prohibit banks from engaging in fractional reserve banking. All money must be backed one hundred percent by gold. Loans must be based upon the transfer of gold from saver to borrower via a professional banking system, which exacts a small profit for its intermediation services.
There is no role for government in this system beyond insuring that banks do not engage in fraud by lending out more money than they have gold on deposit. Government should not insure deposits or regulate lending in any way. There is no role for a central bank in this system either. This is laissez faire banking based upon market generated money. This is freedom. This is the cure.
All the above is a lie.
The fact is that this current crisis, as with all previous crises in the past one hundred years, was caused by government interference in the financial markets. Specifically it is government’s creation of fiat money-- money backed by no commodity; that is, nothing of intrinsic value—that is primarily responsible for our economic problems. This money has two sources—the Fed’s printing press and bank credit expansion. This “deadly duo” touches off the boom/bust business cycle. This business cycle is not something inherent in capitalism. A commodity based money and a legal prohibition against bank credit expansion will end these vicious, wealth destroying and, ultimately, liberty destroying economic crises.
Money is as much a moral as an economic good. Real money is part and parcel of the market economy. It originates as a widely accepted commodity that comes to be used, through the market process, as indirect exchange. As such, its value increases beyond demand for its intrinsic use to include a new demand as something to be exchanged later for some other good. Thusly, real money facilitates the exchange of “something for something”. This is its moral component. But fiat money—that is, money manufactured by the government and backed by nothing—always enters the monetary system as a counterfeit “something for nothing”. There are two corrupt sources of this counterfeit evil.
The first evil source is Federal Reserve monetization of the government’s debt, meaning that the Fed buys government bonds with money that it creates out of thin air. Government itself benefits directly, when, for example, it pays bureaucratic salaries, buys goods and services, and when it rewards its constituents, such as political contributors and voters, through earmarked targeted spending. The first recipients of this new money can purchase goods at the current lower price. Subsequent recipients pay higher prices, because the supply of money increased and pushed up the price level.
Furthermore, this money creates even more money via the “fractional reserve” banking system. Recipients of government spending deposit the checks into their bank accounts; then their banks deposit the checks with the Fed. Bank reserves increase, and banks are allowed to pyramid around ten times the amount of the new and excessive reserves into new loans. These new loans are matched, dollar for dollar, with an increase in the money supply, because banks lend money by crediting the borrower’s checking account. The borrowers spend the money, of course—that is why they borrowed it in the first place. Thusly, bank credit expansion creates new money based upon DEBT. We shall see shortly how fragile this system can be.
Thus far, bank credit expansion has triggered a boom. New projects are started, because the increased quantity of money lowers the interest rate, making long term projects—those for which the cost of funds is most important—now appear to be feasible. Factories expand, mines open, etc., all of which may take years before bearing any real fruit. The problem is that the consumer has not changed his spending habits. He has NOT decided to save more. He purchases immediate, consumer-type goods in the same relationship to his savings as before. In fact the boom may prompt him actually to increase his consumption-to-savings ratio. Therefore, there is no new capital for the successful and profitable completion of these longer-term projects, so these “malinvestments” must be abandoned. Since the projects are abandoned, they never generate revenue for paying off their bank loans. As loans default, the money supply drops, because a large component of the malinvestment was funded by loan generation--when the loans fail, the money disappears.
Now the banks are in trouble. Their capital is reduced dollar for dollar by the loan defaults. It is foolish to ask them to resume lending, because their capital-to-asset ratio is so low. They must build capital before they can begin lending again. But this is not the worst consequence of building the money supply out of debt. The reduction of the money supply reduces overall spending in the economy. This impacts even businesses that did not expand and that previously were healthy and profitable. Their revenue decreases too, driving them to unprofitability. The total amount of goods and services in the economy cannot be sold with this lower volume of spending UNLESS PRICES DROP. Therefore, it is crucial that government do nothing to prevent prices, including the price of labor, from falling. Only a lower price level can bring the economy’s supply of goods and services into equilibrium with less money. As Professor George Reisman of Pepperdine University has explained, falling prices are the antidote to deflation (where “deflation” is defined as a fall in the supply of money).
Perversely, the government recently raised the minimum wage and gave Fannie Mae and Freddie Mac its UNLIMITED guarantee!
Government’s current attempts to prop up prices are doomed to failure. Supply can clear only at lower prices. The malinvestment, especially in housing, must be allowed to liquidate on as good terms as current owners, mostly developers, can get. There is an excessive supply of housing in the economy in relation to other necessary goods. Reports of government efforts to “revive housing” are indications that government is thwarting the necessary correction via its many bailout programs. A more encouraging report would be that the price of housing is falling precipitously. This would be welcome news to all seeking housing—don’t we all love a sale?
We are doomed to repeat these boom and bust cycles, probably with even greater intensity due to government’s foolish interventions, as long as government can print money out of thin air and banks can create even more money out of debt. No regulations can prevent this cycle. In fact some government agencies, such as Fannie Mae and Freddie Mac, are trying to rekindle the boom while other government agencies, such as bank regulators, claim that they can so regulate bank lending to prevent any future malinvestment. This is impossible. The problem lies in the very nature of the monetary system, which sends false signals to bankers and bank regulators alike, inducing them to fuel another unsustainable boom. Money is lent on the cheap to precipitate projects for which no real new capital exists. This money built on debt will vanish as it has in the past, wiping out the hopes and dreams of tens of millions. The lower quantity of money means that total spending will be inadequate to clear the production side of the economy at current, boom-induced high prices. Yet, even though lower prices are the only cure, government and organized labor fight this cure tooth and nail.
The answer lies in driving a stake through the heart of this deadly duo. First of all, return to commodity money, most likely gold. Gold money can be neither created nor destroyed. Once brought into circulation, gold money remains in circulation. Total spending remains the same; only prices change—usually downward, based upon productivity gains—very gradually over time. Next, prohibit banks from engaging in fractional reserve banking. All money must be backed one hundred percent by gold. Loans must be based upon the transfer of gold from saver to borrower via a professional banking system, which exacts a small profit for its intermediation services.
There is no role for government in this system beyond insuring that banks do not engage in fraud by lending out more money than they have gold on deposit. Government should not insure deposits or regulate lending in any way. There is no role for a central bank in this system either. This is laissez faire banking based upon market generated money. This is freedom. This is the cure.
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