Predicting the Price Level

A key disagreement between the Austrian economists and Keynesian economists is over the consequences of expanding the money supply. Keynesians claim that increasing the money supply will cause a beneficial increase in economic activity, whereas Austrians claim that increases in the money supply cause all manner of bad consequences, one of which is the lowering of the purchasing power of all money currently in circulation. The most visible sign of such loss of purchasing power is a general rise in the price level. Therefore, it is important that the Austrians answer the Keynesians who say that the Austrian monetary theory is wrong, because the government’s pump priming, trillion dollar stimulus spending and the Fed’s massive asset purchases have not caused runaway price inflation. In this essay I will answer this criticism by explaining the fundamental forces at work to explain the relationship between the money supply and the price level and the forces of government intervention that make short term price level predictions impossible.

The Quantity Theory of Money

At the foundation of our understanding of money and prices resides the quantity theory of money. At this most basic level it is axiomatic that the price level is the intersection of the quantity of goods for sale on the market and the amount of money available to purchase these goods. Prices can rise for only two reasons. One, the quantity of money rises faster than the quantity of goods for sale. Two, the quantity of goods for sale drops faster than the quantity of money. Of course the reverse is true about a falling price level. Prices can fall for only two reasons. One, the quantity of money falls faster than the quantity of goods for sale. Two, the quantity of goods rises faster than the quantity of money.

Let’s use a simple example. Assume that there is only one commodity for sale in the economy. One hundred units of this commodity are produced. The money supply consists of one thousand units of currency; we’ll use dollars as our money supply unit. The only price that will clear the market of all goods offered for sale is ten dollars per unit. ($1,000 divided by 100 units) Let us suppose that there is a production improvement that allows the market to produce two hundred units of the same commodity. Then the market-clearing price will be five dollars per unit. ($1,000 divided by 200 units) Likewise, let us assume that the money supply increases to two thousand dollars while the ability of the market to produce goods remains the same at one hundred units. Then the market-clearing price will be twenty dollars per unit. ($2,000 divided by 100 units) From this simple example one can clearly see that, if we admit that the U.S. economy produced more goods today than it did twenty years ago, then the primary reason that prices have not fallen is that the money supply increased concomitantly. Likewise, if prices are higher now than they were twenty years ago and real economic output is essentially the same, then the culprit must be an increase in the money supply. But most of us grant that the U.S. economy produces more “stuff” than twenty years ago. So if the price level is higher, the only explanation is an increase in the money supply. Had the money supply remained stable, the only way that the market could have cleared the larger supply of goods would have been for prices to fall.

(Since 1990 M2 has increased by a factor of 2.62 while nominal GNP has increased by 2.57, which leads one to the conclusion that the economy has not really grown at all in terms of real goods and services in two decades. All of the increase in GNP can be attributed to higher nominal prices caused by an increase in the money supply.)


The Three Uses of Money

The quantity theory of money is at the foundation of understanding money and prices, and it does explain long-term trends. But other factors operating within this foundational theory determine market prices in the short-term. One of those factors is an explanation of the purposes to which money can be used.

There are three and only three uses for money—to hold (hoard), spend, and invest. Of the three, only the combined size of the spend-and-invest components determines the price level; i.e., spending and investing are those components of the money supply that are brought to market to purchase goods available for sale. As the total quantity of spending and investing increase in relation to the quantity of goods and services brought to market, prices will increase. If either or both of these components decrease, prices will decrease. Importantly, if the money supply increases and all of the increase goes into hoarding, the price level will remain the same.

Suppose that the Fed printed enough paper money to give everyone in America one million dollars. Since there are 300 million Americans, the money supply would increase by 300 trillion dollars! Surely that would trigger higher prices! But let us also assume that every American took the money and placed it under his mattress. He did not spend one cent. What would happen? Well, the money supply would increase by 300 trillion dollars, but the price level would remain the same. All the new money would have gone into hoarding and would have no impact on prices.

An Ever-Changing Money Supply

So far our discussion of how money affects prices assumes that there is no intervention by an outside, coercive agent that attempts to manipulate both the total size of the money supply and the three uses of money. Unfortunately that is not the case. The government intervenes regularly and inconsistently in monetary matters, making it almost impossible to point to one or two factors that will have the most impact on prices.

The most important interventionist governmental body is the Federal Reserve Bank, our central bank, which almost always attempts to expand the money supply. It “adds liquidity”, mostly by increasing bank excess reserves. Right behind the Fed is the Treasury Department, which spends the money. Both attempt in various ways to stimulate the economy by ensuring that any increases in money go into the spending and investing buckets and not into the holding/hoarding bucket. Currently the Fed and the government want all of the money to go into the spending bucket exclusively, so that the GDP numbers will rise. You see, the government measures the size of our economy by how much we spend, so it tries to manipulate this number in a variety of ways. The “cash for clunkers” program is a case in point. If nothing else causes one to question this whole paradigm, the government’s claim that destroying still useful, but older vehicles adds to our economic well being should end such naiveté.


It is beyond the scope of this article to explain the many ways that the Fed increases excess reserves and the effect this increase can have over time on the size of the money supply. Let us just say that although the Fed has less than perfect control over the money supply in the short run (and the short run can be years long), it is the size of total reserves and the reserve requirements that establish the outside parameters of the money supply. Typically bank excess reserves are around only $2 billion or less, not a great deal in an economy the size of ours. As of July 28, 2010 bank excess reserves stood at $1.012 trillion dollars! Since we have a fractional reserve banking system, the potential exists for banks to expand our money supply by many multiples of these excess reserves.

Conflicting Government Interventions

But it gets even more complicated! While one department of the Fed tries to expand the money supply, there is another whose actions prevent it—the bank examining force. As the left hand of the Fed hands out reserves to all comers, the right hand ensures that those reserves will not be converted into money via lending. In fact the right hand of the Fed--and other bank regulatory agencies, such as the FDIC--currently exercise a deflationary impact on the money supply. These agencies are forcing banks to charge off suspect loans against capital. When a bank’s capital ratio falls below that required by bank regulations, the bank has only two choices. It can attempt to raise capital, a difficult thing to do these days, or it can reduce the size of its balance sheet by reducing loans outstanding. Loan reduction has a deflationary effect on the money supply.

Add to this structural issue the fact that there really aren’t many good loans out there, which would create new money as desired by the Fed’s left hand, and you can see why all that additional liquidity has yet to reach its potential as the basis of new money. The key word here is “yet”. The potential for a massive increase in the money supply exists, however.

The Risk of Hyperinflation

Now we get a glimpse of what has been happening. The Fed has been adding liquidity mostly in the form of excess reserves. As yet these excess reserves have not been employed by the banking system to support an increase in the money supply via new lending...the bank examining force has blocked this route. The money that has found its way into peoples’ pockets has stayed in peoples’ pockets--it has been hoarded. There is no way to predict the end to hoarding, the end to bank recapitalization, and the end to bank loan problems. But when these deflationary factors do end, American prices will rise as the hoarded money and the increased money created by increased lending flow into spending and/or investing. At that point we will enter what Ludwig von Mises called the “danger zone”. No one will wish to hold depreciating dollars; they will be spent as rapidly as possible, creating the real possibility of what Mises called the “crack-up boom”. Despite the tough talk by Fed Chairman Bernanke, the Fed will be powerless to prevent this debacle. Money will become worthless.

Understanding the Relationship between Money and the Price Level

One of the conundrums of current economic life is why the increase in the money supply had not caused runaway price inflation. Furthermore, the federal government has run a one-trillion-dollar deficit this year, with promises of more for several more years, while at the same time interest rates have fallen to unprecedented low levels. Both of these phenomena seem to violate economic law. Shouldn’t more money drive up prices? And shouldn’t government’s massive borrowings cause interest rates to rise? Yet prices for most goods have remained stable and the interest rate is at historic lows. Has all economic law been shown to be fallacious?

In this essay I will explain the fundamental forces at work to explain the relationship between the money supply and the price level, which will, coincidentally, help to explain the low rate of interest. There is no violation of economic law. The seeming anomalies stem from the fundamental error of placing economics within the realm of the physical sciences and not in the realm of the social sciences. The view of economics as a physical science leads one to the conclusion that economics is mechanical and can be explained by formulas; whereas understanding economics as a social science leads one to understand that human volition cannot be predicted or reduced to mathematical formula with substantive and temporal exactness.

The Quantity Theory of Money

At the foundation of our understanding of money and prices resides the quantity theory of money. At this most basic level it is axiomatic that the price level is the intersection of the quantity of goods for sale on the market and the amount of money available to purchase these goods. Prices can rise for only two reasons. One, the quantity of money rises faster than the quantity of goods for sale. Two, the quantity of goods for sale drops faster than the quantity of money. Of course the reverse is true about a falling price level. Prices can fall for only two reasons. One, the quantity of money falls faster than the quantity of goods for sale. Two, the quantity of goods rises faster than the quantity of money.

Let’s use a simple example. Assume that there is only one commodity for sale in the economy. One hundred units of this commodity are produced. The money supply consists of one thousand units of currency; we’ll use dollars as our money supply unit. The only price that will clear the market of all goods offered for sale is ten dollars per unit. ($1,000 divided by 100 units) Let us suppose that there is a production improvement that allows the market to produce two hundred units of the same commodity. Then the market-clearing price will be five dollars per unit. ($1,000 divided by 200 units) Likewise, let us assume that the money supply increases to two thousand dollars while the ability of the market to produce goods remains the same at one hundred units. Then the market-clearing price will be twenty dollars per unit. ($2,000 divided by 100 units) From this simple example one can clearly see that, if we admit that the U.S. economy produced more goods today than it did twenty years ago, then the primary reason that prices have not fallen is that the money supply increased concomitantly. If the money supply had remained stable, the only way that the market could have cleared the supply of goods for sale would have been for prices to fall. Since most price statistics show that prices have not fallen and in fact have risen somewhat, then the only explanation is that the money supply increased.

(Although the quantity theory of money knows no definitive author and has been known for centuries, Professor George Reisman has written extensively on the subject. I recommend pages 505 and 506 of his magnum opus Capitalism for a brief explanation. Then the reader can continue elsewhere in this magnificent book for further and more detailed discussion of money, prices, and production.)

There Are Only Three Uses of Money

Yet my illustration above and recent experience seem to make a mockery of economic science. I had said that economics was not a physical science, and yet I used mathematics to illustrate my point. Is not mathematics a physical science? Furthermore, my illustration would predict that prices must rise when the money supply increases, and yet in recent months the money supply HAS increased and prices have not followed. Should we discard the quantity theory of money? No. The theory is at the foundation of understanding money and prices and it does explain long-term trends. (Since 1990 M2 has increased by a factor of 2.62 while nominal GNP has increased by 2.57, which leads one to the conclusion that the economy has not really grown at all in terms of real goods and services in two decades. All of the increase GNP can be attributed to higher nominal prices caused by an increase in the money supply.) But other factors operating within this foundational theory determine market prices in the short-term.

There are three and only three uses for money—to hold (hoard), spend, and invest. Of the three, only the size of the spend-and-invest components determine the price level; i.e., spending and investing are those components of the money supply that are brought to market to purchase goods available for sale. As the total quantity of spending and investing increase in relation to the quantity of goods and services brought to market, prices will increase. If either or both of these components decrease, prices will decrease. Furthermore, if the money supply increases—that is, the total of all three uses increases—and all of the increase goes into hoarding, the price level will remain the same.

(As is the case with the quantity theory of money, the concept that there are only three uses of money was not discovered by any single economist, but I refer the reader to chapter seven of Hans-Hermann Hoppe’s The Economics and Ethics of Private Property for an excellent discussion of the subject.)

Here is an example that I use in my Austrian economics class at the University of Iowa: Suppose that the Fed printed enough paper money to give everyone in America one million dollars. Since there are 300 million Americans, the money supply would increase by 300 trillion dollars! Surely that would trigger higher prices! But let us also assume that every American took the money and placed it under his mattress. He did not spend one cent. What would happen? Well, the money supply would increase by 300 trillion dollars, but the price level would remain the same. All the new money would have gone into hoarding and would have no impact on prices.

Now we get a glimpse of what has been happening for several years. Central banks around the world have been printing money, but most of this money has been hoarded. When governments spend money without first borrowing it from the existing monetary stock or taxing it from the citizenry, the new spending eventually goes into bank reserves. Since the banks have not increased lending, the money supply has not increased. As of July 28, 2010 bank excess reserves stood at $1.012 trillion dollars. This is a form of money hoarding. Another form of money hoarding is the buying of sovereign debt. For example, the U.S. government has sold hundreds of billions of dollars of debt to our trading partners. This happens when foreigners foolishly believe that running large trade surpluses is somehow a national advantage. But Frederic Bastiat exploded this fallacy over a century and a half ago in his essay Government. By holding its currency cheap in order to export goods, a country impoverishes itself by shipping useful goods in exchange for depreciating paper money. Since these foreign governments have no use, so far, for American products, they buy U.S. Treasury debt in order to “park” the money until some future date. This, too, is a form of hoarding, because the money does not finance spending and/or investing.

The End to Hoarding

There is no way to predict the end to hoarding, but when it comes American prices will rise: the hoarded money will flow into spending and/or investing. At some point the hoarded money will burn a hole in peoples’ pockets. The first holders of large amounts of American money will be able to exchange their dollars for goods, services, and assets at today’s prices. But as this hoarded money flows into spending and investing, prices will start to rise. Other holders of hoarded U.S. dollars will realize that nothing can stop the depreciation of the dollar, as illustrated by relentless price increases. Now we will enter what Ludwig von Mises called the “danger zone”. Even if the central banks try to stop the flow of hoarded funds into spending and investing, they will be unsuccessful because market psychology has changed. No one will wish to hold depreciating dollars; they will be spent as rapidly as possible, creating the real possibility of what Mises called the “crack-up boom”. Money becomes worthless.

Just as the psychology of today’s market mitigates holding dollars, once the floodgates have been opened the psychology of the market will reverse. In The Mystery of Banking Murray N. Rothbard explained that market psychology can change very slowly, as in America for the first two decades after World War II, or very rapidly, as in Germany after World War I, where in 1923 the world witnessed the worst crack-up boom ever to appear in a modern, industrial nation. Germany recovered only when it exchanged the old mark for the new Rentenmark at one trillion old marks for each new Rentenmark and the Reichsbank pledged to hold the supply of Rentenmarks stable. When the Reichsbank kept its word gradually the people regained confidence in their currency. But the damage had been done. The resources of the middle class had been wiped out, and, more importantly, the German peoples’ confidence in social institutions had been shattered, opening the door to the demagoguery of National Socialism.

It Can’t Happen Here

Americans are no less ruled by the iron laws of economics than are other, less fortunate peoples. Never in the history of the world has so dominant a world power engaged in such massive money debasement. The trillions of dollars held around the world represent claims upon the productive sector of the U.S. economy that simply cannot be met--at least not at today’s prices. The German hyperinflation of 1923 wiped out the German government’s war reparation debt, but at the stupendous price of ushering in the fascists. Likewise, the U.S. could technically pay its national debt by so devaluing the dollar that it effectively robs dollar holders of their good faith claims upon American resources. I would remind xenophobic Americans, who may believe that robbing foreigners is of no concern, that Americans hold dollar claims, too, and would suffer just as much, if not more.

At the present time there is no better market alternative to holding American dollars. All currencies are fiat currencies, managed by the whim of politicians buying votes with more entitlements. But forces are building to end American hegemony in monetary affairs. The Chinese, the Indians, the Arabs, and the Russians are floating rumors of issuing a gold-backed currency, and the market always rewards a better product. It would be the greatest tragedy to befall this nation, if our foolish government destroyed our currency at the height of our productive capacity, making indirect, peaceful, cooperative exchange an impossibility. It can happen here!

My Letter to the NY Times re: Blog Prophet of Euro Zone Doom

From: patrickbarron@msn.com
To: letters@nytimes.com
Subject: Letter-to-the-Editor
Date: Thu, 10 Jun 2010 14:04:01 -0400

re: Blog Prophet of Euro Zone Doom

Dear Sirs:
Mr. Edward Hugh may be correct that the Euro will fail, but it will not fail as a direct result of cultural differences among its members. It will fail because the European Central Bank (ECB) succumbed to political pressure to abandon its primary responsibilities to keep the currency stable and chose instead to destroy the Euro's purchasing power. Profligate nations can coexist in the same currency zone as financially responsible nations, but eventually the profligate nations will be forced to mend their ways or they will run out of money. This is good--one of the benefits of a sound money is its use as a unit of account, revealing when one is accumulating capital and when one is destroying it.

The Greek financial crisis revealed that nation's path to destruction much earlier than otherwise because it was on the Euro and could not hide its problems by debasing the drachma. This was a Greek financial crisis that is merely denominated in Euros; it was not a Euro crisis. It became a Euro crisis only when the ECB bought Greek bonds and forced the European Union (EU) nations to guarantee them against the will of their citizenry. At that point it became obvious that the more responsible nations might be forced to leave the Euro Zone by the overwhelming demands of their citizenry to do so.

It is not true that debasing one's currency is a means to restoring financial solvency. Debasing the Euro may spur EU exports temporarily, but it is no long term solution. By making imports expensive a debased Euro will raise the cost of living for the common man in Europe and even raise the cost of those imports that are used as factors of production in export industries.

The world's politicians should abandon their search for a quick financial fix that does not exist. If some claimed that they have found one, you can bet that the costs either are hidden or will be borne by politically unpopular minorities. The EU had a golden opportunity to allow the free financial market to impose discipline upon the Greek government. The Greek people should demand that their leaders keep them in the Euro Zone, because that is the surest and quickest path to forcing their government to abandon its destructive fiscal policies. More debt or currency debasement will only hide the problem, make it bigger, and result in a worse situation in the future.

Patrick Barron

My Letter to the NY Times re: China's Currency Manipulation

Re: China Uses Rules on Global Trade to Its Advantage, by Keith Bradsher--March 15, 2010


http://www.nytimes.com/2010/03/15/business/global/15yuan.html?scp=1&sq=China%20Uses%20Rules%20on%20Global%20Trade&st=cse

Dear Sirs:
Mr. Bradsher gets the consequences of state currency manipulation exactly backwards. No country can inflict damage upon another by manipulating its own currency; all harm accrues to the citizens of that country alone. By holding its currency weak, China subsidizes exports at the expense of its own citizens. The citizens of China's trading partners enjoy cheaper and/or better quality goods, while the Chinese experience higher prices due to trading more renmindi for foreign currencies than the unhampered market would allow. In economic terms this is called "importing inflation". Mr. Bradsher makes another crucial error when he makes the claim that "unlike extra government spending in the United States and other countries, currency intervention does not expand global demand, but shifts it from other countries to China." No, the process is the same, whether within one country or among several countries; that is, that governments cannot increase total demand. Mr. Bradsher describes perfectly the "fallacy of composition", whereby it is assumed that, since a government can shower benefits on one economic entity, it can shower benefits on all economic entities. On the contrary, government spending rewards some at the expense of others. Neither currency manipulation nor government spending will increase resources, but, instead, will transfer them--at a cost, of course--from some segments of the economy to others. The so-called stimulus spending in the United States does not increase total demand within our country any more than China's currency manipulation increases worldwide total demand.

Patrick Barron
Adjunct Instructor in Austrian Economics
University of Iowa
Iowa City, Iowa

Fed Chief Wants to Eliminate Bank Reserves

The link below is a transcript of Federal Reserve Chairman Ben Bernanke's Feb 10, 2010 testimony to Congress. The last line of the final note at the end of the letter has the pertinent statement that the Fed may eliminate reserves completely.

http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm

Here is my analysis:

With over a trillion dollars in excess reserves right now, the banking system is not limited by reserves. Since its founding in 1913 the Fed has steadily destroyed the public's understanding of real money. Therefore, eliminating reserves fits into the scheme of things as just another move away from any semblance of sound money.

Without reserve requirements, the banking system would have no limits to its manufacture of money; therefore, I see this as a step toward government allocation of credit--the government's ultimate goal. Because the banks would be in a position to expand credit without limit, the government could claim that only it has the foresight and the power to prevent another crisis. This is the banking system as it was practiced during the communist reign in Eastern Europe. I taught many East European bankers at the University of Wisconsin in the late '90's. They related that the role of bankers during the communist era was simply to implement orders from the government; that is, allocate so much credit to the steel industry, so much to agriculture, etc.

If sound money is eliminated and the banks are not required to hold any reserves, there hardly is any other way to conduct banking.

THE VELOCITY OF MONEY AND THE BUSINESS CYCLE

The velocity of money is the one of the factors that determines GDP. The well-known formula is GDP = M x V; that is, Gross Domestic Product equals the quantity of Money times its Velocity. Velocity refers to how many times a given quantity of money is spent during the period under consideration, usually one year. Less understood is how changes to money’s velocity come about. The formula makes clear that a decrease in velocity can adversely affect GDP and vice versa. But, that just begs the question, what causes changes in monetary velocity?

The primary determinant of how often a given quantity of money is spent is the desire of the public to hold money; that is, the public’s demand for money. When demand for money is high, meaning that the public wishes to hold more money in the form of cash balances, the velocity of money decreases. Likewise, when the public’s demand for money is low, velocity accelerates. Therefore, we have entered the realm of perception, which is not an exact science in the sense that one can establish a formula of the magnitude and time frame for changes in perception. Nevertheless, it is possible to establish the factors that eventually will change perception and, therefore, will cause the demand for money to increase or decrease.

The demand for money is influenced primarily by the quantity of money. This simple statement reveals something very important—that if the quantity of money changes very little, then the demand for money will change very little and the economy will experience stable conditions. Commodity money—that is, gold and silver—experiences very small changes in its quantity; therefore, one would expect that commodity money velocity would change very little. But even in the days of the gold standard, the demand for money varied. The reason was that the money supply was not backed one hundred percent by gold but, rather, only a fraction of the money supply was backed by gold. The rest of the money supply was anchored in bank loans instead. As banks increased lending during temporary boom times, the quantity of the fiduciary media, as Ludwig von Mises called this money not backed by gold, increased, which caused the demand for money to decrease and money’s velocity to rise. This is the very definition of a boom. However, eventually this increase in the money supply causes prices to rise, among other evils, revealing that the boom is unsustainable. There does not exist any new, real capital to fund it.

When bank loans become uncollectable, the quantity of fiduciary media decreases. Now the demand for money increases dramatically, as the public scrambles to convert their fiduciary media—bank checking accounts now of questionable value—into currency. This increase in the demand for money causes a decrease in money’s velocity, exacerbating the bust. The only way out of this predicament is for prices to fall, so that the remaining, smaller supply of money will be sufficient to allow the market of goods and services to clear.

All this can take quite some time. In today’s fiat money, central bank monetary system the bust phase can be papered over for quite some time with increases in fiduciary media. But the demand for money detects subtle changes, thusly precipitating changes in money’s velocity. For instance, rising prices are a signal to money holders to reduce their demand for money. A reduction in money demand causes its velocity to increase, putting further upward pressure on prices. If there exist other assets in which the public can easily invest, then one would expect to see upward price movements. Stock market and commodity price increases are symptoms of such movements out of money, reflecting reduced demand for money, furthering an increase in money’s velocity.

It is typical of such boom periods that credit is readily available. Businesses, then, are more prone to reduce cash holdings in the certainty that bank loans can be used as a substitute for ready cash to meet business needs. This drop in business demand for holding money is a further spur to an increase in money’s velocity. Furthermore, since central bank manipulation of the interest rate in a downward direction was the precipitous cause of the temporary boom, business has even less incentive to moderate its borrowing in lieu of holding cash. Better to invest in inventories that may rise in value than hold cash, especially when loans not only are easy to obtain but are cheap, too.

Therefore, what economists see as an increase in money’s velocity is actually a rational decision by market participants to reduce their demand for money following central bank intervention to lower the interest rate and ignite a temporary boom. But, when the boom turns to bust, the reverse happens. Now the market demands more cash at a time when fiduciary media is being wiped out by bank loan losses. Prices fall, making it wise to hold cash in the expectation of even further price reductions. Businesses begin to hoard cash when bank lending dries up in the face of falling bank capital ratios due to loan losses. And they stop investing in inventories that become less valuable each day. Finally, the public bails out of a falling stock and commodity market in favor of the comfort of cash holdings. Money velocity drops even more.

In a free market, capitalist economy marked by little government intervention and the existence of sound—that is, commodity—money, the demand for money and its inverse, the velocity of money, are of little interest to economists let alone the public. The demand for money reflects real choices based upon market forces rather than opportunistic or defensive choices based upon wild, temporary swings in economic fortunes based upon government and central bank intervention. Prices change very slowly. Banks are institutions of probity and practice good asset-liability management; that is, they match loan maturities to deposit maturities. This may sound dull to some, but it beats the wild boom/bust cycles that create millionaires one day and paupers the next.

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.

The Path to Sound Money and a Vibrant Economy

The greatest challenge facing the United States and Western Civilization—which includes all those countries engaged in international trade in order to facilitate social cooperation through the division of labor—is the destruction of money by central banks who have the power to expand their fiat money supply to unlimited proportions. Such fiat money expansion destroys the usefulness of money as a vehicle for communicating value through time and space. What will the dollar be worth in terms of apples and oranges in the future and around the world? No one knows, even when we may predict with a great deal of certainty the quantity of apples and oranges that will be produced in the future and market demand for them. It is not the quantity of apples and oranges that makes future exchange problematic; it is the quantity of money that makes it so.

Because societies have recognized that only a stable quantity of money may perform these crucial services to the economy has money always been a commodity itself with certain characteristics, chiefly among them being its scarcity in nature. For, as Ludwig von Mises has explained, any quantity of money may serve all the functions that are required of money regardless of the size or complexity of the economy. It is the crucial characteristic of scarcity—that is, its quantity—that has been undermined by central banks. Already we have seen the deleterious effects of this debasement of money in the form of repeated and ever more violent boom-bust business cycles. These cycles are the external manifestation of “sick” money; they are NOT the external manifestation of “excessive greed” or any other failing of society’s citizenry. “Sick” money has transmitted its disease to society, not the other way around. Therefore, it is imperative that the United States and other Western nations end the expansion of their money supplies and re-anchor them in some commodity of lasting value, namely gold, silver, or some combination of the two. But…how can this be done? That is the crucial question…the elephant in the living room, so to speak.

Let us first establish that the goal of any currency reform is to end at a stroke the further expansion of the money supply. The expansion of money confers no societal benefit whatsoever. More money does not bring into existence, either in the near term or in the longer term, more goods and services than would be produced without its expansion. The truth of this statement lies in its logic and also in historical experience. But these are subjects for another day. The important point is that ANY further expansion of the money supply causes harm; therefore, it is not a question of gradually reducing the expansion of money. No, we must stop any further expansion by even a very small amount.

First, End Fed and Bank Fiat Money Expansion

In our current fiat money environment, two institutions have the legal ability to expand the supply of money—the Federal Reserve Bank (the U.S. central bank) and commercial banks. Most people understand that the Fed can increase the money supply, but few understand that privately owned banks themselves also have the legal ability to increase the money supply. Although the manner in which money expands can be rather complicated (and needlessly so), I will explain the basics. The Fed can inject money into the economy by monetizing the federal debt; that is, it accepts the government’s promissory notes and credits its checking account. Then the federal government spends the money. This in itself increases the supply of money, as can be easily understood, but there is more. When the recipients of the government’s money deposit their checks, bank reserves increase when the bank of deposit sends the check to the Fed for deposit in its reserve account (a checking account at the Fed that is owned by the commercial, private bank. The Fed is the “bankers’ bank.) Now the banking system has “excess reserves” upon which to pyramid more loans and deposits by a magnitude of from ten times to over one hundred times! All the bank must do is make a loan and credit the loan customer’s checking account. It is restricted in the extent to which it may expand its loans and deposits (in equal amounts) only by the amount of its excess reserves. Remember, the Fed created excess reserves when it monetized the government’s debt. Here lies the danger—under normal conditions banks try to remain completely loaned up, utilizing every penny of their excess reserves by making loans and, in the process, creating money out of thin air. In our large economy, excess reserves normally amount to fewer than two billion dollars, an amount considered to be the frictional amount that cannot be fully utilized. Over the past year the Fed has injected massive reserves into the banking system, and now excess reserves stand at over a TRILLION dollars, or five hundred times the historically normal amount!

The Reisman “First Step” to Neutralizing Excess Reserves

At a Mises Institute Seminar in Long Beach, CA last month, Professor George Reisman presented an intriguing plan to prevent the banks from expanding their lending against this massive amount of excess reserves. He recommended that the Fed create even more reserves! But here’s the twist—the Fed should insert enough reserves of fiat money into the banking system to equal the current level of bank checking accounts, BUT at the same time also require 100% fiat reserves against those checking accounts and prohibit the Fed from creating any more reserves thereafter. This step would do two things. Number one, and most importantly, the banks would not be able to convert those trillion dollars in excess reserves into ten to one hundred trillion dollars of new money. Secondly, it would force the federal government either to tax the people for what it spends or borrow honestly from them. Either method would create a natural limit on government spending, forcing it to prioritize and moderate its plans to those more in line with society’s means.

The Barron “Second Step”--Convert Fiat Money to Commodity Money

Governments cannot be trusted to refrain from violating their own laws. They do so, of course, by passing another law to suspend “temporarily” the previous law which put what it considers to be an undue restraint upon its actions. Therefore, we must return to commodity rather than fiat money. The government could do this by simple arithmetic; it could divide the money supply by the number of ounces of gold it holds to establish a legally binding exchange rate of dollars for gold. Currently the most widely used definition of money—M2—stands at $8.4 trillion, and the government owns 260 million ounces of gold. Therefore, it could provide 100% backing of M2 with gold by agreeing to pay out an ounce of gold for $32,308 and, conversely, to buy gold for the same amount. Presently the price of gold has fluctuated between $1,000 and $1,200 per ounce, so a decision to support the dollar at this dollar-to-gold ratio would have unknown economic consequences. Better for the government to establish the ratio at a level closer to the current market level for non-monetary gold. But how can the government do this? If it prints more money to buy gold in the open market, it would not solve its problem—it would have even more fiat dollars to back by the new quantities of gold it received. But, the government has other resources! The government is like a cash-poor but property rich relative--it owns vast expanses of valuable land. In fact the government owns roughly 30% of the landmass of the United States, mostly in sparsely populated areas west of the Mississippi and in Alaska. This is its ace-in-the-hole.

Selling Government Land for Gold Is Doubly Beneficial!

The government has no just cause for owning more land that its normal day-to-day operations require, such as enough land for its military bases and other government office buildings. Its ownership of lands in the western United States and in Alaska has prevented the development of the resources on these lands for the benefit of the U.S. citizens and the world. Like an anorexic who prefers to starve with nutritious food close at hand, the government refuses to allow the development of valuable resources from its land holdings to feed the resource starved economy of the United States. These lands are potentially the most valuable on the face of the earth. Not only do they hold much mineral and vegetable wealth, but they are located in a capitalist country of entrepreneurs, skilled workers, an honest court system, good infrastructure…in essence, all the factors necessary for successful capitalist development. So, not only would the sale of government land for gold allow for the backing of the U.S. dollar by more ounces of gold and, therefore, ease the transition to a 100% gold standard at a better dollar to gold ratio, it would unleash the productive capacity of 30% of the nation’s land resource! This is not rape of the land any more than a farmer rapes his fertile soil or a timber company rapes its well-managed forests. Selling land allows it to be capitalized and managed for productive benefit into perpetuity, the opposite of government’s so-called management, which is nothing more than locking land away as if it did not exist.

In conclusion, the U.S. can quickly take the necessary steps to return to sound money and at the same time unleash a new, real economic boom. It needs to take steps first to freeze expansion of the money supply, followed by a judicious sale over time of its valuable land holdings for gold. The gold proceeds of the sale would allow the government to back its currency 100% by gold at fewer dollars per ounce. The U.S. would once again have the world’s strongest currency and most productive economy. There is nothing preventing us from taking this action but our own foolish adherence to failed economic theory.

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.

WHAT IS FRACTIONAL RESERVE BANKING? And why do most Austrian economists want to end it?

There are few things more misunderstood than the practice of fractional reserve banking and its impact on our economy. There are reputable Austrian economists on both sides of this issue. Most, like myself, believe fractional reserve banking to be fraud and injurious to the efficient and ethical working of the economy. (Read Jorg Guido Hulsmann’s excellent The Ethics of Money Production, available at the online bookstore at Mises.org.) Others, such as Ludwig von Mises himself, would not ban fractional reserve banking but would allow the market to regulate it. Mises was more concerned with the prospect of government intervention in the monetary system and feared that laws against fractional reserve banking would be the camel’s nose under the tent mitigating in favor of more regulation.

It is difficult to understand fractional reserve banking without understanding some of the history of banking and how fractional reserves originated, for our current system maintains a fiction that has long since been made irrelevant. That irrelevancy is that something of lasting value backs our money; that is, something that would exist even if the nation/state that issued the monetary unit ceased to exist. Think of the difference in value between a gold coin of ancient Rome and the Confederate dollar, for example.

Fractional Reserves and Bank Runs

Historically banks came into existence as warehouses for gold and other precious commodities. Gold has always been a universal medium of exchange, even when other commodities competed with it for acceptance in the market. The first bankers were goldsmiths, who owned safes in which to store the raw materials of their profession. Wealthy individuals paid goldsmiths a fee to store their gold, and goldsmiths issued them receipts. Eventually these individuals started using the warehouse receipts as fiduciary media; meaning that rather than go to the goldsmith and redeem one’s gold in order to purchase something, these individuals started endorsing over their warehouse receipts. Thusly, the warehouse receipts circulated in the economy rather than the gold itself. Over time the goldsmiths realized that they could issue warehouse receipts in excess of the gold held in their vaults and reap a profit, because at no time did all the people who owned warehouse receipts for gold travel to the bank at the same time to redeem their certificates for gold specie. Now, the goldsmiths did not simply spend the excess receipts on consumer goods; rather, they lent them to borrowers and earned interest. (Doubtless the goldsmiths and even some economists today do not consider this practice to be fraud.) Since there now were more warehouse receipts for gold circulating in the market than gold in the vault to back them, it was said that the gold reserves amounted to only a “fraction” of the outstanding claims. Notice that two things had happened. One, the goldsmith gains from his fraud; that is, he made a profit (if the loan was repaid on time) from the use of goods that he did not own. Two, the money supply increased by the amount of the excess warehouse receipts. However, the money supply could not increase by very much, as we shall see.

The goldsmith, now transformed into a banker, was limited by the market in how many fractional reserve receipts he could issue. All would be well until the public became concerned that the bank had over-issued certificates. (Sometimes rumors were started by his competitors.) Then the holders of the certificates would “run” to the bank to redeem them for gold. A bank run had been born. Then the bank’s only course of action was to call in its loans, get paid in gold, and then pay its depositors in gold. If his borrowers could not repay, the banker would be forced to declare bankruptcy.

Sound Money and Credit Money

Notice that the certificates backed 100% by gold could always be redeemed without any difficulty. Thusly, such money could never be the source of inflation or deflation. But the excess certificates were not back 100% by gold; they were backed by the promise of the borrower to repay--that is, this money was backed by DEBT! If the debt could not be repaid, these excess money certificates could not be redeemed for gold. The money supply—composed of indistinguishable certificates, some backed 100% by gold and some backed only by debt—had been expanded when the goldsmith issued the excess certificates. Now the money supply shrank back to its former, sounder level.

Of course, money certificates today are backed by nothing—not gold, nor silver, nor cockleshells. The money we use is fiat money, and yet governments everywhere maintain the fiction that banks must hold reserves in some small percentage amount in order to cover their customers’ deposits. But what are these reserves? These reserves are debt, too. Let me explain.

The Basis of All Fiat Money Is Debt

In the U.S. the only money that may be used legally “for all debts public and private” is a Federal Reserve note. These notes—the money we carry in our wallets—are referred to as “standard money”. There is no recourse to anything beyond these paper notes. If a person wished to “redeem” his Federal Reserve note, he could go to the nearest Federal Reserve Bank and redeem it for…another Federal Reserve note. It might be one that was brand new off the printing press, but it would be the same type of note. If that person deposited his Federal Reserve note in a bank, the bank would create a demand deposit, also known as a checking account. The bank would send to the Federal Reserve Bank the Federal Reserve notes that it collected whose numbers were above what it deemed necessary to meet the normal needs of its customers for pocket cash. These notes would be deposited in the bank’s reserve account at the Fed. (A bank’s “reserve account” is nothing more than a checking account.) But the bank would not be required to maintain a 100% reserve account balance to match the total of all of its demand deposits. It is required to hold only a fraction in reserve--along a sliding scale, the fraction becoming greater for larger banks--to meet the withdrawal needs of its customers. The rest of his reserve account balance is “excess”, meaning not required to meet his “reserve requirement”.

Excess Reserves Become the Building Blocks of the Money Supply

So what can a bank do with its “excess reserves”? It can create a loan to another of its customers, credit that customer’s demand account, which will increase its reserve requirement and reduce its excess reserve position at the Fed by a fraction of the amount of the loan. The bank—actually, the banking system--can continue to lend and create demand deposits in this fashion until its reserve account balance matches its “reserve requirement”. This is how banks create money out of thin air, and one can readily understand the enormous ability of the banks to expand the money supply from this updated fractional reserve banking practice.

The key point is that the bank created the new demand deposit by creating a loan—the loan is an asset on the bank’s books and the demand deposit is a liability. Thusly, money in our bright new world of fractional reserve banking is backed by DEBT! In order for a deposit to be redeemed would require that the loan be repaid. If the loan cannot be repaid, the bank cannot meet its withdrawal obligations and goes bankrupt. This has been the cause of bank failures since the inception of modern banking.

The Central Bank Creates Reserves and Makes the Banks Bankrupt-Proof

But, enter a new player--the central bank. Our Federal Reserve Bank (or European Central Bank, or Bank of England, or Bank of Japan, or Bank of China) was created to prevent bank insolvency. The central bank stands ready to loan our bank unlimited funds so that it may honor its deposit withdrawal obligations. There are several ways that the central bank can accomplish this, such as purchasing bank assets or simply by a direct loan (called the discount window). It really doesn’t matter as long as the Fed can place the proceeds in the reserve account of our troubled bank. Ah, but where did the Fed get the funds to place in our troubled bank’s reserve account? Why, it created them out of thin air, too! For example, it can credit the federal government’s checking account in exchange for federal debt—called “monetizing the federal debt—or it can buy assets as discussed above, or it can lend directly to the banks at favorable terms. The central bank has become a money creation machine.

A Thing of Frightening Beauty—a Siren Song to Bankers and Politicians

Thusly, all central banks are the source of what the public calls inflation, creating money out of thin air to prop up bank credit expansion made possible by fractional reserve banking. The entire Rube Goldberg mechanism is a thing of frightening beauty, beloved by college professors who force their students to understand all the gory details, but especially beloved by bankers and politicians who can literally paper over bad debt with massive increases in the money supply. It does seem as if we have entered a new era in which it can be made impossible for banks to go bankrupt and fail to pay off their depositors. The central bank need only to invent some new rationale for replenishing the troubled banks’ reserve accounts; thus, the Troubled Asset Relief Program (TARP) and other such programs were born. The long-term harm to the economy is found on many fronts, from higher prices (perhaps even hyperinflation) to moral hazard to civic unrest as interest groups fight one another to feed at the government’s feed trough. Each dollar of new money, born of debt and not production, reduces the purchasing power of all other dollars already circulating in the economy. Nothing has been produced, not one nut or bolt, not one new car…nothing. But more money creates the temporary illusion of prosperity. One’s home increases in value. One’s 401K increases in value. Jobs are plentiful. New office buildings pop up to house all the new businesses that are born. The only problem is that nothing has been built on true savings, only debt. Yes, it is a brand new world, but it is a frightening one that cannot last.

A Glimpse of Things to Come

Officials from the Federal Reserve Bank are touring the country—very quietly, it turns out—to gauge populist opinion of its handling of the current financial crisis and to garner support to increase its regulatory power to become the sole financial regulator in the country. I attended one such event in Des Moines, Iowa, which was hosted by Iowa Citizens for Community Improvement (CCI). This group has been around for several decades and is aligned with a national organization called National Peoples’ Action (NPA). NPA claims to have been instrumental in passing the Community Reinvestment Act in the 1970s, which extorted banks to make loans to those with less than stellar credit records and to make mortgages on properties in blighted areas. Both CCI and NPA are proud of their achievements and see no linkage between their lobbying efforts to force banks to make marginal loans and the resulting sub-prime lending crisis.

Several hundred people—my estimate is at least five hundred—crowded into a Des Moines church and sat for two and a half hours while CCI and NPA officials berated the hapless consumer affairs representatives from the Federal Reserve Bank’s Board of Governors in Washington, D.C. and consumer affairs representatives from the Federal Reserve Bank of Chicago, the local Fed office for Des Moines. About a dozen people were paraded before the Fed panel, telling their tale of financial woe. In this day of the tell-all reality show, no one seems embarrassed to confess his personal financial ineptitude in front of hundreds of people and the recording cameras. And sorry tales these were. And like all tell-all reality shows, no one took personal responsibility for his actions, which was just fine with CCI and NPA.

The Link Between Personal Irresponsibility and Big Government

A Ms. Kathleen Keest, currently of the Center for Responsible Lending and a CCI board member from its founding in the 1970s, listed four supposed fallacies that prevent the common man from getting his fair share of society’s goodies: the acceptance of personal responsibility, the desire for personal choice, concern over unintended consequences, and the free market. According to Ms. Keest, all four are false gods. It is impossible for man to take personal responsibility for something as complex and important as borrowing money; personal financial planning is too complex to allow the common man to exercise his free choice; the concern over the unintended consequences of government action should be dismissed out of hand; and, the free market is the cause of all our problems in the first place.

Now, consider how wonderfully Ms. Keest’s analysis dovetails into the Fed’s desire to increase its power. True, the poor punching bags from the Fed’s consumer affairs offices had a rather nasty day being yelled at for over two hours, but the benefit is that Ms. Keest and the other professional busybodies actually called for INCREASING THE FED’S POWERS! Undergoing hours of tongue-lashings is worth the price of obtaining even more power and bigger budgets.

Of course most of those in attendance at this meeting did not understand that the Fed itself is the underlying cause of our problems. Speaker after speaker laid the blame squarely on the shoulders of the lenders, who forced their money upon an unsuspecting public, all the while knowing that the public could not repay the loans. The logic of this argument is so ridiculous that I will not take the time to refute it. But let me at least point out that all the many regulatory agencies also failed to detect the crime of irresponsible lending at its inception. Now everyone’s hindsight vision is 20/20.

Despite the fact that few in the audience understood that massive money expansion, which led to massive credit expansion, was at the heart of the current crisis, there is one thing that everyone understood perfectly clearly; that is, that the Fed has enormous power to transfer wealth. Speaker after speaker stated this fact as the reason for inviting the Fed to the meeting—they all want the Fed to shower its benevolence upon themselves and not others. The common mantra was that it is time for the Fed to help Main Street and not Wall Street. The Fed bailed out Wall Street and now all the big banks are paying big executive bonuses with their bailout money. It’s time for the same thing to happen on Main Street. Exactly what this means was not made clear, and I believe it was left unclear on purpose, so as not to alienate potential allies in calls for more money creation and more government economic intervention.

The Slippery Slope to Tyranny

This travesty of a supposed public meeting to gain the peoples’ input perfectly illustrates the kind of society to which we are plunging headlong. It has taken the demagogues a hundred years to realize that control of the money supply is control of people. Therefore, special interest groups like CCI and NPA do not focus their efforts on the peoples’ representatives. They lobby for increasing the power of government agencies who then can be browbeaten into doing their bidding. One of the most frightening moments of the meeting occurred when a George Goehl, executive director of NPA, whipped the crowd into a frenzy by showing a short video of NPA demonstrating in front of Fed Chairman Bernanke’s Washington, D.C. home. The demonstrators eventually obtained a promise from Bernanke’s Secret Service bodyguards that they would deliver a list of demands to the Fed chairman. Then Mr. Goehl told the audience that just hours before the meeting we were attending he had exacted a promise from the Fed consumer affairs representatives that Fed representatives would meet several times a year with CCI and NPA representatives. The audience cheered wildly and Mr. Goehl basked in the adulation.

So, welcome to the future, where public policy will be made by non-elected bureaucrats who make deals with special interest groups who intimidate public officials in their private homes. Do our bidding and we will support your efforts to obtain greater power and prestige for yourselves. Of course, you must give us what we want and not what other special interest groups want. Like the Bolshevik revolution in Russia, the most radical groups will work cooperatively with other special interest groups, such as farmers and small businessmen, to form a coalition with greater lobbying power. But such coalitions are temporary. The most radical groups will take over, just as the most radical and charismatic members will take over the surviving pressure group. This is consistent with Friedrich Hayek’s explanation of why the worst rise to the top in politics—only the most amoral individuals lacking all concern for the rights of others are willing to persecute their fellow man in the name of some supposedly greater societal good.

But, of course, there is no greater societal good that justifies the use of power and coercion to control the lives of the many for the benefit of the few. Ms. Keest and Mr. Goehl struck me as of the type who always rise when a foolish people are willing to give control over their lives to self-designated masters in the hope of trading freedom for security. It is only just that such a people lose both their freedom and their security.

Dumping the Dollar—a Case of Government Schizophrenia

(This essay was written in collaboration with Benjamin Harnwell, Secretary General of the Working Group on Human Dignity, European Parliament)

Many economists, both inside and outside of government, are very worried that foreign governments may dump their dollar holdings, touching off massive price increases in the U.S. and possibly bringing down our financial system. It is a real danger.

According to the U.S. Treasury Department’s own figures, as of June of 2008 foreigners hold over $10 trillion as currency reserves. China and Japan each hold $1.2 trillion. The U.K. holds $.8 trillion. Tiny Luxembourg and Ireland hold $.6 and $.4 trillion respectively! Even Russia holds huge amounts of dollars—over $.2 trillion.

Contrast these overseas dollar holdings with the Fed’s official tally of the domestic money supply as of April 2009. M1 (currency and other checkable deposits) totaled $1.6 trillion. M2 (M1 plus savings, money market funds, and small time deposits) totaled $8.3 trillion. So even compared to the most expansive measure of the domestic U.S. money supply (M2) foreigners hold more dollars than domestic holders.

If any country with significant dollar holdings decided to dump them for some other currency, the result would be inflation in the U.S. on par with the worst days of the Carter administration and, if panic sets in and others join, hyperinflation and the destruction of our economy.

Jorg Guido Hulsmann explains the process with this example in The Ethics of Money Production. (Just insert the name "China" or "Japan" for his hypothetical country Ruritania.)

"If we assume that Ruritania is a very large country with substantial dollar reserves even by world standards, then the mere announcement that the Ruritanian government will switch to the euro standard might incite other member countries of the dollar standard to do the same. This could precipitate the dollar into a spiraling hyperinflation. The dollars would sooner or later end up in the United States, the only country where people are forced to accept them because of their legal-tender status. Here all prices would soar, possibly entailing a hyperinflation and collapse of the entire monetary system." (Pages 232/3)

As Hulsmann explains, the "leadership of the U.S. Federal Reserve is aware of this situation." (Page 233) OK. That’s reassuring. But if U.S. officials are concerned about the terrible consequences of a POSSIBLE dumping of dollars on the U.S. market, why are they UNCONCERNED about the consequences of their own efforts to stimulate the economy, which involves the same mechanism that they so fear from foreign actions; that is, massive expansion of the money supply?

The government has taken two actions that will expand the money supply every bit as much as possible foreign actions to dump the dollar--expansion of the monetary base by the Federal Reserve Bank and the Obama administration’s spending spree. Currently excess reserves held by banks in their accounts at the Fed total close to $1 trillion. Reserves are the building blocks of the money supply. Through their lending actions, commercial banks can create money up to many multiples of their reserves…a good rule of thumb is ten times. So the money supply could be increased by a factor of ten or more when the banks start lending, as surely will happen over time. Furthermore, the Obama administration’s stimulus package of $.8 trillion is funded entirely by fiat money; that is, money printed from thin air. Compared to the current level of M1 at $1.6 trillion, this action alone will expand the money supply by 50%.

None of this makes sense from the perspective of economic fundamentals. Ah, but it makes perfect sense from the perspective of expanding government power and control!
Through its stimulus program, the government can shower funds on its friends. It can buy votes. It can reward labor unions by bailing out the very industries that union action did so much to destroy. It can create bureaucratic jobs for its sycophantic hangers-on. Finally, the resulting budget deficits become justification for punishing ones enemies through tax increases.

If foreigners dump their dollars, the government will have no control over where they will enter the American money supply, and, therefore, the government will not be as able to direct the influx of money to politically connected friends. This is the only difference. The American price level will rise tremendously, regardless of the source, and hyperinflation and economic chaos are real possibilities.

Of course, no nation would be in this predicament had it remained on the gold standard. Money spent on overseas goods (imports) would have reduced the domestic money supply, lowering domestic prices, and causing a reversal of the gold flow (via exports) as that country’s products became bargains on the international market. But under the fiat money supply, by which the supply of money is limited only by the prerogative of the monetary authorities—which means that there is no real limit—the domestic money supply can continuously expand even as dollars are sent overseas for decades, accumulating in the coffers of foreign central banks until the dam bursts, so to speak.

The U.S. must take three actions immediately to prevent hyperinflation. Number one, it must rescind the stimulus package. So far less than five percent of the stimulus package has been released. Good! Rescind the rest of it. Number two, the Fed must take back the $1 trillion in excess reserves before the banks start lending. It can do this buy raising the interest rate through open market operations, offering to sell the banks its huge holding of government bonds at reduced prices. Number three, the U.S. must reform its monetary system—it must peg the dollar to gold, abolish the Fed, and prosecute fractional reserve banking. This will end the politicization of the money supply.

With a gold dollar, inflation and deflation will become things of the past along with the boom/bust business cycle that credit expansion, not based upon true savings, is the primary cause. Unable to monetize its debt, the government will be forced to control its budget. We will return to a limited rather than an activist, destructive government. Our Founding Fathers will look down upon us with approval.

The World Does Not Need a Reserve Currency

In last week’s essay I explained that the failure of the U.S. to uphold its commitments under the Bretton Woods Agreement to redeem the dollar for gold at $35 per ounce was the primary cause of the great inflation in all the world’s currencies. Just to recap events: In 1944 the allied powers agreed that the dollar would serve the same role as gold for the purposes of international currency settlements after World War II. At that time the U.S. owned (or safe kept for allied governments who were at war and whose territories were threatened by invasion) most of the gold reserves of the allied central banks. As long as the U.S. would keep its dollar to gold ratio at the agreed-upon $35 per ounce ratio, central banks around the world could settle their trading accounts in dollars. These central banks would maintain an agreed-upon ratio of dollars to their local currencies just for this purpose. The world would be on a "gold exchange standard". If one country inflated its currency, its trading partners would demand dollars in exchange far in excess of the profligate country’s ability to pay. It would be forced to deflate. Just as the case under a true international gold standard, that country’s prices would fall, its exports would increase, thus generating dollar reserves and all would be back to equilibrium. The key to this whole program was the promise of the United States itself not to inflate. But, of course, this is exactly what it did.

Theoretically, the U.S. should have been placed in the same position as any other country that inflated its currency--instead of running out of dollars, the U.S. would run out of gold. Its gold reserves did dwindle, which should have set off alarms at the International Monetary Fund, which was charged with the job of auditing the gold supplies of the U.S. and ensuring that it honored its obligations. But the IMF did not do its job. Why? This enters the arena of psychology, but I imagine that the Cold War had something to do with it. The U.S. alone was capable of protecting the Allies from the growing Soviet threat. Perhaps the Allies and the IMF felt an obligation not to criticize their protector. Who knows? But once France got the atomic bomb and a president—Charles de Gaulle—who felt comfortable acting as an equal on the international stage, it no longer felt that it needed to cow tow to the U.S. So in 1963 France demanded to be repaid in gold for its ever-increasing stockpile of dollars. This should have instilled much needed fiscal and monetary discipline in the U.S., but it did no such thing. President Johnson committed the U.S. to fighting a foreign war AND instituting new welfare entitlements—his "guns and butter" policy. In 1969 President Nixon could have reversed this policy, but he feared that the inevitable recession would mean the loss of a second term, so he simply reneged on Bretton Woods and "closed the gold window" in 1971. So much for U.S. honor and prestige!

The world kept spinning ‘round, though, and the dollar continued to be used as a reserve currency--there simply was no other. In the 1980s President Reagan and Federal Reserve Chairman Paul Volcker put America’s economy on a two decade long, inflation-free growth path. It appeared that the world could indeed operate with a fiat reserve currency; that is, one not tied to gold. But administrations change and now it is apparent to our trading partners that our continued inflation means that the dollars they hold will become increasingly less valuable. We are cheating our trading partners.

China was so concerned that it floated the idea of creating an IMF-issued "super reserve" currency to replace the dollar. Although the Chinese government later claimed that it wasn’t really serious, no one believes them. But China has pegged its yuan to the dollar at too low a (yuan) rate. Many state-owned industries in its export-oriented economy would go bankrupt if China revised its exchange ratio with the dollar. This would mean lower spending in China and probably would trigger a recession. So China demurs…at least for awhile.

But the answer to the problem--that has been brewing for more than six decades now--is NOT to cobble together some new Frankenstein monster than no one will be able to control. The answer is right before our eyes—return to gold. Each country should set its own ratio of local currency to gold and settle all trades in the actual commodity. Then no country—not the U.S., not the European Community, not China, nor Japan—will be able to inflate its currency without destroying its ability to import goods. It will run out of gold for settlement purposes and be forced to deflate. No special governmental agreements are needed. Gold would settle just as checks settle today—by debiting and crediting each nation’s gold accounts wherever they may be. Just as no business can operate with zero money—it is forced to economize—no nation would be able to import continuously by papering the world with its currency, as the U.S. does today. As the profligate nation’s gold reserves dwindled, its ability to import would dry up; prices would drop, making its goods a bargain for export; its gold reserves would start to climb and all would be well. Just as explained by Jean Baptiste Say, all trade tends toward equilibrium.

IMF bureaucrats managing a super currency will be no more reliable than were U.S. bureaucrats managing the dollar. They, too, will succumb to political pressure to over-issue an IMF reserve currency, and the entire world will be off and running in an inflationary binge that will destroy world trade. As Professor Thorsten Polleit of the Frankfurt School of Finance and Management says, we all must make our peace with gold. It is in the best interest of the common man, because no one can manipulate it. Gold is money and money is gold. Gold is inflation and deflation proof, because it is not built upon debt, as is the current case with all the world’s fiat currencies. So it cannot be inflated when banks lend against a small reserve and it cannot suffer deflation when those loans are not repaid. This is the cycle through which we have just passed—money supplies inflated by profligate lending and now money supplies deflated when those loans go sour. This cannot happen with gold as long as governments strictly enforce currency convertibility and shut down banks that engage in fractional reserve banking.

So why doesn’t the world return to gold? Because governments benefit the most. The fiat money that we all use may be manufactured in infinite amounts by governments. Would we expect a counterfeiter, who was protected by law in his ability to print money, to deny himself its benefits? Of course not. Governments are no different. They are the primary beneficiaries of their fiat money monopoly. They may spend as they please. They are not obliged to tax the people or borrow honestly from them. It is a heady and corruptive power that appeals to the tyrants among us. No, reform must come from the people. Either that or reform will come only after a total collapse of our monetary system, which would cause untold hardships and possibly even massive death around the world as the ability of the people to engage in indirect exchange was destroyed. So monetary reform is no academic issue. It is a life and death issue.

A good start to reform would be for the citizens to become informed of monetary matters. Demand that real economics be taught in our schools. Demand that our politicians stop lying to us about the causes of our problems. End the demagoguery that seeks out enemies in the business class and attempts to place guilt upon the public, calling us "addicted to spending" and/or too "consumer oriented". This is nonsense. The people are perfectly capable of determining and guiding their own financial futures as long as the medium of exchange allows them to plan and understand the reality of their situation. Our government is the problem. We should demand that it confine its actions to those enumerated in the Constitution. Our founding document, the highest law of the land, does NOT give the government the power to print money. It assigns government the RESPONSIBILITY of protecting us from counterfeiters; it does not give government the power to BECOME A COUNTERFEITER. Enforce the Constitution. End the Fed. Return to gold. Restore our freedoms and our rights. Is this really such a radical demand?

CAN WE RETURN TO SOUND MONEY?

No one alive today has ever experienced sound money; that is, money backed by a commodity of lasting value, such as gold or silver. So it is not surprising that even many who understand the concept and advantages of sound money have many serious questions about the possibility of reinstating a gold standard. Their questions usually occur in this order: Is fiat money so ingrained in our economy and our way of life that re-conversion is not possible? What are the obstacles? Would the U.S. be able to reconvert on its own or would most of the world have to join us? What would a transition entail?

If it really isn’t possible to reconvert and/or the obstacles and transition costs are too great, lets just forget the whole thing and concentrate our efforts on getting reformist politicians and bureaucrats in positions of power. In other words, get better men to rule in a benign dictatorship. Regrettably this really is not an option. Our current fiat money system will fail. No such system has ever met the test of time. All…let me repeat that…ALL such fiat money experiments have failed. Once men realize that they hold the power to create and spend money in unlimited amounts, no appeal to the better angels of their nature will prevent them from abusing their commissions. So, our only option is to reconvert.

Fortunately, fiat money is not so ingrained in our economy that it cannot be replaced by a gold standard. The main obstacle to doing so is not some mechanical barrier. Although such a transition would be easier the more countries that agreed to participate in a coordinated re-conversion, the U.S. could go it alone. And, finally, there are several intellectually solid transition strategies from which to choose.

There is no question that many American institutions cannot survive in their present form under a sound money environment. It is these beneficiaries of our fiat money system that present the most serious obstacle to re-conversion. I refer, of course, to government itself. A fiat money system enables government to expand its power by stealing the product of the people’s effort without overt taxation or honest borrowing. Such is the situation today. Our government--with the cooperation of our central bank, the supposedly independent Federal Reserve—spends money created out of thin air and intervenes to drive down the rate of interest. So far this strategy appears to work, and this is a shame. For the inevitable rise in prices and the interest rate will be delayed, perhaps for more than a year. Then the government’s apologists will blame price rises on everyone but themselves—greedy oil companies, greedy oil sheiks, greedy merchants, etc. If you think that the people will not be so foolish as to believe such nonsense, this is exactly the message that the government has so successfully spread as the cause of our current financial crisis. Therefore, you can imagine the tremendous propaganda effort from our government to discredit efforts to end their gravy train. Our response should acknowledge the source—such cries of panic are to be expected and should be ignored.

So, we have determined that there really is no choice but to re-convert to sound money, and we have discounted the objections from government itself, the primary beneficiary of our fiat money system. Can we go it alone or do we have to get the cooperation of our major trading partners? Professor George Reisman has addressed this issue (and more) in great detail in his magnum opus Capitalism and many other venues. He concludes that an internationally coordinated re-conversion would prevent the likely rise and subsequent fall in prices in the U.S., a one-time cycle caused initially by "outside gold" flowing into the U.S. and inflating the U.S. money supply to be followed by a later fall in U.S. prices as our sound money regime takes hold. If the European Central Bank, the Bank of Japan, the Bank of England, and the Bank of China coordinated re-conversion with us, there would be no such "outside" gold to initiate the cycle. But, even if these countries demurred in our re-conversion effort, Reisman explains that the U.S. would be the eventual winner, because the cycle would end and the dollar would gain against all other currencies as time progressed. Furthermore, the U.S. would not suffer the frequent boom/bust business cycles caused by our current, manipulated fiat money system.

Finally, how would we do it? There are several scenarios. Some economists claim that all the U.S. has to do is repeal its legal tender laws (laws that prohibit any other money from circulating within the U.S. other than our fiat dollar). A free money environment would allow the wonders of competition to work. The best monies would drive poor ones from the marketplace, a reverse of Gresham’s Law. Good money would drive out bad in the same way that any superior good drives lesser ones from the market. Whether only those currencies backed 100% by gold would circulate or if some lesser currencies also would circulate would be at the discretion of the real rulers of the marketplace—the consumer.

Most other scenarios give some role to government, at least for the transitional period. The U.S. confiscated the gold of the U.S. citizenry in 1934, forcing them to surrender their gold in exchange for depreciating federal reserve notes. So government, in effect, stole the nation’s gold and still holds vast quantities of it in its vaults. This gold would be returned to the people in proportion to their money holdings via some mechanism, of which there are many worthy ones. Then the U.S. dollar would be fully convertible to gold at some market determined parity price, such parity price then established by law as the legally enforced price of the dollar. Any dollar holder could redeem his dollars for gold at the parity price. At this point the U.S. dollar would become, in essence, a warehouse receipt for gold. The U.S. would be on the gold standard.

The sooner the U.S. re-converts to the gold standard, the sooner the U.S. economy will recover and, more importantly, the sooner the liberties of the people will be restored. No longer will the government be able to hide the true cost of its spending and blame others for the inevitable deleterious consequences. It must either tax the people or suffer higher interest rates. Then the people can decide whether such spending is warranted, because they will see first hand that they must pay the cost of such spending. Of course, it has always been the case that the people must pay for government spending, but now this fact will be immediately discernable and subject to the people’s control. That is the America in which I want to live. How about you?