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.

My Letter to the Wall Street Journal re: Regulating CDS's

Wednesday, 10Mar10

Dear Sirs:
I see that the government has succeeded in its efforts to focus attention away from itself as the real cause of the financial crisis and onto "evil speculators". The Fed's feckless attempts to create wealth out of paper money was doomed from the start. A false boom ignited by fiat money credit expansion cannot be distinguished from a real economic expansion financed by savings and capital accumulation. Now the government is trying to make everyone believe that a free, capitalist economic system is inherently unstable and an easy victim of unscrupulous villains, when the truth is exactly the opposite.

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

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.

A DECADE OF FIAT MONEY INFLATION

The Fed's own monetary statistics reveal a decade of fiat money inflation and Fed irresponsibility.

In ten years M1, the narrower definition of money, expanded by one half.
M2, the broader definition of money, expanded by 80%.

Bank REQUIRED reserves expanded by 70 percent.
TOTAL bank reserves expanded by 2,600 percent.
EXCESS reserves expanded by 18,500 percent!

Banks have an incentive to expand lending to the maximum extent possible. The only institutional restraint upon bank lending is their reserve requirement. If the banks utilized their excess reserves efficiently over time (as they have in every year except the years of the Great Depression of the 1930s), we can calculate the level that M1 and M2 could reach if the January 2010 ratio of reserves to those two money aggregates remained operative:

M1--$31,436 billion (the current level of M1 is $1,676 billion)
M2--$159,729 billion (the current level of M2 is $8,463 billion)

In other words, it is possible for M1 and M2 to expand by a factor of 18 times their current size. This is a prescription for hyperinflation. It is the hubris of the Fed that it can withdraw excess reserves once it sees prices moving higher. This is not correct. If the Fed were to withdraw reserves in sufficient amounts to forestall higher prices, it would have to send the economy into a true depression, allowing banks and their customers to go bankrupt. The only restraint upon the banking system right now is the lack of capital, the paucity of good loans, and the determination of bank regulators to prevent another fiat money induced economic bubble.

The Irresistible Sirens' Song of Inflation

In The Odyssey, Homer’s second epic poem of the Trojan War (The Iliad was the first), Greek hero Odysseus, sacker of Troy, must endure many challenges before he can return to his homeland. Some challenges were new and unexpected, but, as an experienced sailor, Odysseus was aware of the terrible Sirens. The Sirens were beautiful young women who sang irresistible songs that lured sailors to their deaths on rocky shoals. Odysseus wanted to hear the Sirens’ songs, yet he knew the danger. So he ordered his men to fill their ears with wax, to prevent them from hearing the Sirens, and then to tie him to the ship’s mast and not release him under any circumstances. As the ship approached the danger area, Odysseus heard the Sirens’ songs and begged his crew to untie him so that he could follow the Sirens. But, his crew ignored Odysseus and the ship passed the danger. Odysseus had heard the irresistible songs and understood that no man, not even a heroic and disciplined warrior, could refuse the temptation of the Sirens.

Homer’s epics can be understood at many levels, and I choose to interpret the story of the Sirens’ songs as a warning of man’s inherent weakness. There are some temptations so compelling that man must not allow himself to be placed in circumstances where he may succumb. Even when the temptations are known and understood, he must scrupulously avoid coming into contact with them. Powerful men are especially prone to these temptations, feeling superior to other men and certain that they can avoid the penalties involved. As such, they behave recklessly, only to discover that they are as human and as weak as anyone. The fall from grace of Tiger Woods comes to mind.

The temptation of inflation is inherent in our fractional reserve, central banking system in which fiat money is forced upon the populace by legal tender laws. This system creates a central bank lender of last resort—our Federal Reserve Bank—that manufactures money out of thin air, just as would any counterfeiter. But our Federal Reserve has even more power than a counterfeiter, because it operates not in the shadows and outside the law but in full daylight and with all the instruments of compulsion of the modern nation-state. No one may refuse to use its money and no one may use any other. Its only restraint is that imposed by the conscience of the men who are temporarily in charge of its machinery. This is indeed a powerful Siren song to inflate; that is, to print money.

The first temptation is so shower the banking system with money so as to ignite an unsustainable boom. Few chairmen of the Federal Reserve have been able to withstand this temptation. Even Allen Greenspan, who considered himself a “hard money man”, chose to bask in the adulation of the nation during the short-lived Boom years; therefore, he printed money to ignite one Boom after another. His successor, Ben Bernanke, has proven to be just as weak. But the Sirens’ songs are more compelling than merely desiring the limelight, as Ben Bernanke will attest, for he has given us an example of the ultimate irresistible temptation to destruction. Even when it is clear that inflation of the money supply has caused the Boom to turn, inevitably, to Bust, the Fed chairman is compelled to inflate even more. Here is why.

The essence of our fractional reserve banking system is the Fed’s ability to ignite a Boom through an increase in bank reserves. The Fed uses its power to buy assets, usually treasury bonds, to give the banking system additional reserves. The money that the Fed uses to buy these assets is created out of thin air. But that is just the tip of the pyramid, so to speak. As the banks lend money they create money out of thin air—the proceeds of bank loans become checking account money. This money was also created out of thin air, but in many multiples of the reserves that the Fed created out of thin air. Therefore, and this is crucial, this new money is backed by nothing more than debt—the debt of the banks’ borrowers.

As the Boom turns to Bust, due to the lack of real capital made available from real savings rather than money creation, the loans become worthless and, more importantly, the money supported by those loans vanishes. Now the central bank, the lender of last resort, hears the irresistible Sirens’ songs for even more money creation. All segments of society call upon the Fed to bail out the banks’ depositors, most of who are innocent bystanders of this Boom/Bust drive-by shooting. Who can resist the demands of the bankers, their shareholders, and their customers to create even more money so that the banks can honor their depositors’ checks? Everyone, from the president of the United States to the most modest widowed retiree, will ask if this entity called the central bank, formed with the ability to manufacture as much money as it itself deems necessary for the smooth functioning of the economy, is to stand idly by and watch innocent depositors lose everything. Everyone will question the justice of such an act.

Does there exist any person who, as chairman of the Federal Reserve, would be able to live peacefully among his fellow Americans who believed that their plight could be alleviated by his order? Grandma’s checking account must be made secure, at least in nominal dollar terms, from whatever size loan is required from the Fed to Grandma’s bank, regardless of the bank’s ability to repay the loan. Even though we know that the money for this loan is manufactured out of thin air, exactly the same as the money that kicked off the unsustainable Boom, we do not care. The consequences of another irresponsible act must be ignored, just as the original irresponsible act—the printing of money out of thin air—was ignored. Only now the Sirens’ song is even greater.

So, we sail toward the rocky shoals of national bankruptcy in full knowledge that we do so out of an irresistible compulsion. Better to have never heard the Sirens’ song of inflation in the first place. Better to never have given up sound money—gold and silver—in the first place. Better to never have given up responsible banking—one hundred percent reserves--in the first place. Better to never have trusted the weakness of man to withstand the irresistible Sirens’ song of inflation that appears destined to destroy modern economies everywhere in the world.

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.

Trade Protectionism Does Not Enhance National Security

As a general concept, free trade has many supporters. Most of us agree that trade with other nations is a good thing. We get stuff that we would not otherwise have and/or it is much cheaper. Examples include many food items that grow only in special climates, such as fruits and vegetables. Some foodstuffs cannot be grown here, or they can be grown only in special climate-controlled facilities. If the U.S. prohibited the importation of these foreign foods, we would not have them at all or they would be very high priced and, therefore, not available on the mass market. Therefore, it is not difficult to advocate free trade in these items, although even here the U.S. shamefully prohibits the free importation of sugar cane from poor Caribbean nations and corn from poor African nations, just to name two of the most egregious protectionist policies. These are nothing more than gifts to mostly rich American sugar and corn producers, at the expense not only of the American consumer but also, perhaps more importantly, at the expense of poor farmers in the Caribbean and Africa.

The Case for Trade Protection

But, I digress. The issue is protectionism as a necessary policy in order to enhance national security. Here the argument takes many forms. All involve the construction of straw men--meaning, the advocates of protectionism start from some extreme premise, whereby, once the premise is accepted, there appears to be no rational or logical alternative to protectionism. For example, one common argument assumes that some key industry just would not exist if Americans were to be allowed to purchase this industry’s product from overseas producers who had a natural advantage or were subsidized by their governments. The steel industry is often cited. It is assumed that the American steel industry is the target of foreign governments. These governments are hostile to the U.S., although not officially at war with us. These governments extend subsidies to their steel industries in order to monopolize the U.S. market, depriving American producers of necessary revenue and driving them out of business. Once the American steel industry has been destroyed, these governments can do two things. They now can inflate the price of steel so that our steel-dependent industries, such as autos, cannot compete internationally, or they can boycott sales to the U.S., making it impossible for us to arm ourselves with ships, tanks, artillery, etc. Under this scenario, our free trade posture makes us so dependent on one foreign producer that we would be forced to become a backward nation or surrender militarily. What is wrong with this argument?

The Impossibility to Monopolize the World Market

Well, first of all, when writing the above scenario, I found it difficult to construct this straw man so that the argument would appear possible. From a practical standpoint, the argument appears ridiculous. There are many nations eager to sell steel (or whatever good the protectionists cite) on the world market. If China, for example, subsidized steel to such an extent and for such a long time that it did manage to destroy American steel companies, what would it gain? As soon as it raised its price or refused to sell to us, other steel producers would rush in to sell on our market, for many countries have robust steel industries. What is China to do—sell subsidized steel all over the world in an attempt to destroy the steel industries in every country? This hardly seems plausible. But this practical objection is not the most powerful one against the protectionist argument. Read on.

The Inalienable Right for Man to Trade with Man

Economic theory helps us clarify the free trade position to such an extent that even seemingly practical objections can be viewed with renewed skepticism. One of the key concepts in Austrian school economics is that man trades with man and that both expect to benefit. Notice that I did not say that America trades with China. The free trade position stands upon the right of the individual to trade with whomever he desires. This right does not end at our nation’s borders. We have just as strong a right to trade with foreigners as we have with next door neighbors. This is a right embodied in our Declaration of Independence, which calls our right to life, liberty, and property (the pursuit of happiness) as inalienable, meaning that it is God given and may not be given away much less taken from us by legal means. Our Constitution became the practical implementation of this principle. As our “Supreme Law of the Land”, our Constitution lays a sacred obligation at the foot of government to protect us in our inalienable rights. Our Constitution makes no provision for our government to grant these rights or even to interpret them. Seventy-five years after our Declaration of Independence a Frenchman explained this issue in as clear terms as have ever been penned. Frederick Bastiat, in The Law, stated that it is impossible for government ever to obtain powers that did not once belong to man himself. Because government is a creation of man, man cannot grant to government any powers that he himself did not already possess. Since man does not possess the right to deprive other men of their property, government cannot legally exercise this right, no matter the number of people who clamor for it to do so. This is the philosophical foundation of free trade. Since man has no individual right to prevent his neighbor from trading with anyone he chooses, government cannot obtain the power to do so. But there is more; there is economics.

“Society” Benefits when Man Benefits

A fundamental tenet of Austrian school economics is that man acts in a purposeful way to accomplish something that he considers will be an improvement upon his existing condition. Now, I know the previous statement sounds odd, but the implications of it are far reaching. First of all, it places man at the center of all action. It does not say that societies act; no, it says that man acts. Man is the building block, so to speak, of society; that is, society is nothing more than the aggregate of all men and their actions. No man, no society. Therefore, it follows logically that when man acts in a purposeful way to improve his condition, any subsequent improvement may be regarded as an improvement for society, too. There is no such thing as an improved condition of man that translates somehow into a deteriorated condition for society. This is impossible. Now, this is not to say that man may improve his condition by committing a crime or some other physical harm upon another man. No, he may not. This is the “No Harm” doctrine of Dr. Thomas Patrick Burke of the Wynnewood Institute. When two men agree to trade, both expect to gain, and, in pursuance of their goal, they may not cause physical harm to another man. Notice that I said “physical” harm. Refusing to trade with another does not constitute harm. If I decide to switch my grocery shopping patronage from store A to store B, I have not harmed store A. The fact that I change my car buying patronage from an American company to a foreign company likewise does no harm to the American company. I have gained (or expect to gain, if my research is correct that the foreign car will meet my expectations) and the foreign carmaker gains. If either of us did not expect to gain we would not have traded in the first place. But there is more yet.

All Subsidies Are Transfers of Capital

Some trade protectionists will agree with my analysis of the situation, yet they still will advocate protectionism under the theory mentioned earlier that the foreign carmaker was subsidized by his government. The problem with this theory is that it fails to understand that all subsidies are transfers of capital. If the American government subsidizes its farmers, for example, the farmers gain and the buyers of farm products gain to the extent that their lower price exceeds the cost of the subsidy they provided. Since American taxpayers pay the subsidy to farmers, as a class of farm product consumers they cannot gain. In fact, they lose, since the cost of running the farm subsidy program detracts from the amount of the subsidy the taxpayers send to the farmers and, as a result, the price of farm products are not as low as they would otherwise be. One can see that if China subsidizes its steel industry, it transfers capital to the American consumers. Continue this exercise long enough and widespread enough, and China will ruin its economy by running out of capital.

Furthermore, when Americans buy cheap, subsidized Chinese steel, it is as if our steel industry found a new and more efficient method of production. We now get the same amount of steel by expending fewer economic resources. This allows us to expand our economy into new areas, because we now have increased capital to do so. The Chinese provided that capital to us free of charge! The American production possibility frontier expands while the Chinese production possibility frontier shrinks. But there is more! Cheap Chinese steel makes our steel-using products cheaper on the world market. We gain market share for any good that contains steel, because we can lower our price while maintaining our profit margins. The only way China can recoup some of its loss is to import these cheaper American finished goods. If they refuse to do this, then the subsidy is an out and out gift. But there is even more! To the extent that we build military hardware with subsidized Chinese steel, the Chinese are helping us pay for our national security. If we find that our current level of military preparedness can be purchased at a lower cost, we might decide to expand our military preparedness for the same budget dollars as before!

Conclusion—Free Trade Enhances Our National Security

In conclusion, rather than harm our national security, free trade enhances it. Military goods are cheaper; our economy expands into new frontiers made possible by an increase in capital; our exports are cheaper, so our businesses expand; and employment expands right along with an expanding economy, of course. So, bring on those foreign subsidies!