The Fed and monetary policy: the essentials of economics that encourage central banking
Every citizen needs to understand simple economic theory. Unfortunately, modern economic theory is rife with fallacies that are more readily accepted than the basic economic truths. Economics focuses mainly on human behavior and how it related to the market functions of buying, selling, price, and quantity. The underlying assumption is that all people will behave rationally, or in their individual best interest, if given the opportunity to choose between two or more options. For example, if the price of a desired good is reduced, a rational consumer will purchase more at the lower price.
Fist, let’s discuss the concepts of immediate and delayed gratification. Immediate gratification relates to consumption while delayed gratification relates to savings or setting some earned income aside to be used for some future purpose. My generation was taught to save for down payments and outright purchases while the current generation is being coaxed into consuming now by borrowing to buy whatever they want. This immediate gratification leads to an overall increase in consumer debt which is not necessarily beneficial to a healthy economy since some of that debt will need to be written off as bad loans with the associated costs being distributed to those who did not default on their debt!
The concept of taking good money to pay for bad money is certainly not new. The history of almost every nation includes a period of poor economic performance in which bankers made loans by using their depositor’s money to finance those loans. As a result, the bankers were unable to deliver when their depositor’s asked for their money. This was known as a bank failure. Bank failures led to localized economic collapse since the currency issued by that bank was only circulated in the local community. Each bank was printing their own money and the people looked to the government to step in and regulate bankers so that bank failures would be prevented in the future. This is a fundamental economic fear, the fear of loss of savings, which allowed the people to be fooled by the government when a central bank is established.
A central bank is a single banking system within a nation that enjoys a monopoly on printing currency and controlling the amount of that currency in circulation. When any currency is backed by a precious metal like gold or silver, it is said to be commodity money because it has the intrinsic value of the commodity that backs it. In contrast to commodity money we can have fiat money which is paper money with no intrinsic value that is money only because the national government says it is money; it is backed by nothing more than the faith citizens have in their government. Our dollar, the Federal Reserve notes, is fiat money. Since fiat money costs almost nothing to produce, its intrinsic value is also very near nothing.
The Federal Reserve Act became law on December 23, 1913 when signed by President Woodrow Wilson. The Federal Reserve is charged with controlling inflation and unemployment. Unfortunately for us, those two concepts share an inverse relationship; when one goes up the other goes down. An ideal situation would be low inflation and low unemployment. The fed is not a government entity – it is wholly owned by the member banks. The fed is actually a banker’s bank that essentially transfers all bank risks to the taxpayers. In short; large bankers are allowed to keep their profits when they make good loans, and the losses associated with bad loans are passed on to the taxpayers. It is no wonder people are beginning to hate large bankers. The large bankers tolerate smaller community banks but those little banks do not enjoy the protection from loss that their large counterparts have.
Since a central bank is an essential element of a progressive form of government, the progressive era is said to have begun during the Wilson administration. One can argue that the progressive movement was afoot much earlier since the groundwork for the Federal Reserve Act had to be laid in advance of the legislation. My opinion is that the progressive era began when our political leaders presumed to be smarter than the common people and followed though on that belief by enacting legislation that would slowly increase the scope and power of the federal government by taking liberties away from the people and transferring power to the government. For simplicity, I look at the beginning of the 20th century as the beginning of the progressive era because it seems to mark the end of the free market era of capitalism.
A good reference point comes from The 5000 Year Leap: The 28 Great Ideas That Changed the World, by W. Cleon Skousen.
“By 1905 the United States had become the richest industrial nation in the world. With only 5 percent of the earth’s continental land area and merely 6 percent of the world’s population, the American people were producing over half of almost everything – clothes, food, houses, transportation, communications, even luxuries. It was a great tribute to Adam Smith.”
This economic feat was accomplished by the citizen’s ability to prosper at the maximum level in accordance with the four laws of economic freedom.
1. The freedom to try
2. The freedom to buy
3. The freedom to sell
4. The freedom to fail
Those freedoms are heavily regulated by government in today’s economy and that regulation has led us to the point of an economy that is no longer experiencing unrestrained growth; our current growth is actually anemic.
The fed has control over monetary policy, meaning controlling the amount of money in circulation. Fiscal policy is controlled by congress when they enact laws to change tax rates, tax policy, and government spending. Sometimes the fed and congress work in opposition to each other since they each have separate agendas.
In theory, increasing the money supply leads to lower interest rates, higher inflation and lower unemployment. Economic theory can only describe the relationships between variables; it cannot predict the magnitude or timing of the change.
The fed changes the amount of money in circulation by either buying or selling bonds in the open market. Those bonds are generally sold to Goldman Sachs, a firm that can even borrow the money from the fed, as the lender of last resort, to purchase those bonds. Goldman Sachs will earn a profit on every transaction of buying or selling bonds.
In closing, I want to point out a few facts:
When President Obama was sworn in, federal debt was 40% of GDP and is now 79%. Federal debt is expected to be 72% by the end of 2011.
Federal spending went from 20% of GDP to 25% of GDP on his watch so far, with absolutely no indication that is will be reduced in the short term.
We must reduce federal spending and reduce the national debt; raising taxes is the antithesis of that goal. Spending is the problem and one cannot simply reduce debt by borrowing. That would not work in a household situation and it likewise will not work for a government. Sustainable spending levels by definition must be less than the amount of money available.