The Fed's Folly

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by Scott M. Rosen by Scott M. Rosen

There is probably no better indication of just how powerful the state has grown since the founding of the republic than the fact that the citizens of this nation disinterestedly sit idly by while their government engages in behavior that would send these same folks to prison. The US government can attack foreign nations and cavalierly dismiss the loss of innocent civilian life as collateral damage rather than murder. It can forcibly extract money and property from whomever it wants, yet distinguishes between such confiscation and criminal theft.

While the warfare-welfare state is afforded the right to commit infractions that private citizens are proscribed from engaging in, its operations are underwritten by the nation's central bank, the Federal Reserve. The Fed is responsible for managing the nation's monetary policy and has the sole legal authority to expand and contract the supply of money in circulation.

Just as most citizens idly ignore the murder and plunder committed by their “public servants”, there is hardly a peep from the populace when their unit of store value is assailed by the state in a manner that is proscribed to the people.

In fact, there are few issues that equal the importance of monetary policy that the public has also abdicated all responsibility for to the “experts”. While issues of taxation and military policy are afforded limited debate between the two political parties, the nature of the Federal Reserve is rarely if ever questioned, and in truth, every president since the gold window was closed by Nixon has deferred to the wisdom of the Fed Chairman (essentially Volcker and Greenspan).

This is quite a different state of opinion than existed at one point in the United States when the nature of monetary policy was hotly contested. As well it should have been. After all, there are few institutions in the nation more influential than the central bank and virtually nothing in the economy more important than the medium of exchange. What else permits the government to accumulate such enormous debt which in turn makes possible the ever-expanding federal Leviathan? What other commodity affects so many lives and spheres of economic activity?

Of course, it is understandable why the public (and even most politicians) defer their opinions regarding the issue to those at the central bank and treasury. Monetary policy is hardly the hot button issue that abortion is. Free-floating exchange rates rarely make too many folks' blood boil, and the issues surrounding Fed policy appear to be too complex for the masses to grasp.

In truth, discussions about monetary policy usually invoke such terms and concepts as exchange rates, pegs, government debt, Federal Funds rates, bond purchases/sales, capital flow, M1, M2, M3, MZM, velocity, the Fischer equation, specie and price level: Hardly terms that enter into the lexicon of the average citizen.

While the technical terminology and complex details of monetary policy and theory may be inaccessible to the average individual without an economics background, the basic process that the Federal Reserve engages in to conduct monetary policy is actually relatively simple. All of the detailed statistics, droll testimony by Alan Greenspan before Congress, and mathematical models merely obscure the egregious canard that is central banking.

Essentially, the Federal Reserve Board of Governors (which governs seven different regional banks) serves its primary and most prominent role of “managing” the nation's monetary policy by employing three tools — setting the reserve requirements for private banks, setting the discount rate at which banks may borrow from the Fed, and engaging in open market operations.

Currently, the principal tool used by Fed is the latter option, open market operations. Examining how this process operates illustrates the absurdity and corruption of our monopolistic fiat currency system:

In order to implement its monetary policy, the Federal Reserve Board seeks to control the supply of money stock in the economy. How does the Fed regulate the money supply? By increasing and decreasing interest rates or more precisely, the Federal Funds rate.

In truth, the Federal Reserve, through its Open Market Committee (FOMC), actually targets this rate, which is the rate banks charge each other for overnight loans to cover their reserve requirements and therefore avoid being fined. (If the central bank determined rather than targeted this rate, the price/rate ceilings and floors would result in ubiquitous shortages and surpluses of loanable funds). Due to the fact that the reserve requirements are essentially statutory, any action the Fed takes which either eases or constrains the burden of maintaining these reserve ratios influences the short-term Fed Funds rate.

Here's the key, though: How does the Fed purchase existing debt and thusly conduct this convoluted operation? It simply creates the money out of thin air! When the FOMC buys government debt or sells it at a slower rate, it is said to be easing its monetary policy. When it does the opposite, selling government debt or decreasing the rate it purchases it, the Fed is tightening its monetary policy.

Amazingly enough, if a private citizen decides to reproduce US currency and then circulate it, that's referred to as counterfeit, but if the government essentially does the exact same thing, it's called expansionary monetary policy.

The justifications for the government's meddling with the money supply includes the need to inject liquidity into the economy, target commodity prices or exchange rates, maintain price stability, provide stimulus to the economy, or “cool down” an “overheating” one.

While these reasons might have some (albeit flawed) rationale behind them, they all ignore the greatest (yet largely unmentioned) benefit the central banking system affords the federal government; it permits the state to spend with impunity until it is pushed to the brink of either (or both) bankruptcy and hyperinflation.

Just compare the central government with the state governments. Many state governments consistently run balanced budgets, and those which are less fiscally disciplined can only run modest and temporary deficits. Does this disparity between the fiscal conduct of states and Washington indicate that there is less temptation for state legislatures to offer graft and pork in order to purchase power and votes? Dubious, but what is true is that these state governments don't have an unlimited printing press which can just paper over their liabilities.

Additionally, every extra dollar in currency benefits debtors at the expense of creditors. Therefore, this inflation also permits the federal government to reduce its real interest payments.

Inflation advocates usually invoke one of two major reasons for the central bank's currency manipulation. These are maintaining price stability and stimulating economic growth.

Under normal economic conditions, as productivity increases, the cost of goods decreases, and one can purchase more goods (and services) with fewer dollars. This is the benefit of natural price deflation. However, by artificially maintaining a set price level, the government robs consumers of a better standard of living.

Not only should the value of money fluctuate in the market just like any other good, but the government's regulation of the price level is more illusory than real. After all, it must use inexact estimates such as the CPI and PPI, which don't necessarily reflect all unnatural price changes particularly since the government usually opts not to include certain commodities.

It should also be noted that despite the Fed's supposed defense of a stable dollar, one dollar today is worth about what a nickel was when the Federal Reserve first came into existence.

But the debt chicanery and the phoniness of “stable prices” are not the most insidious element of fiat currency. Recall that expansionary monetary policy (to stimulate the economy, inject liquidity, maintain the price level, etc.) consists of little more than making credit appear out of thin air. How could this system not create massive distortions?

Take a simple example: Suppose there are ten children and ten slices of pizza. Each child receives a coupon good for one slice. Therefore, each child's claim to the entire pizza is 0.1. Now suppose it is one of the children's birthday, and he is granted 2 coupons; however the total amount of pizza remains the same. His claim to the pizza now increases to about .18 while each of his friends' share declines to approximately .09. The birthday boy has now become wealthier (in terms of pizza) at the expense of his friends. This is not dissimilar to what happens when debtors gain at the expense of creditors when the Fed pumps more credit into the economy.

Now suppose the other youngsters are able to discern the unfairness of the situation and demand parity. Their request is honored, but the birthday boy protests, and he receives one extra coupon, but his friends once again become irate. This process continues until each child has an armful of pizza coupons each of which is hardly worth the paper it is printed on. This demonstrates the condition of hyperinflation, a scenario which grows ever more likely with a nation with a massively expanding debt.

The Fed's policy constitutes an attack upon the scarcity and therefore the values of the currency. This problem does not exist with market-based media of exchange such as cattle in primitive society and gold in more modern times.

However, these simple examples only do partial justice to the imbalances created by credit expansion. In the above analogies, everyone is aware of what has occurred and who has benefited. Additionally, the results of the coupon inflation are recognized immediately.

This is not so in a complex economy. All of the effects of the inflation are not uniformly apparent, which results in even greater disruptions.

While all of this may appear awful enough, the distortions created by credit expansion don't end there. Because the method that the Federal Reserve uses to “prime the monetary pump” results in a greater pool of loanable credit, expansionary monetary policy makes borrowing cheaper by reducing the rate of interest. This is somewhat the intent since such monetary policy is said to provide a stimulus to the economy, but does this infusion of liquidity actually create real wealth?

Just as with any other price, the lower the cost of borrowing, the more people there will be who will take out loans. This, however, creates an unnatural situation where individuals and businesses who may have felt that borrowing at a higher interest rate once constituted too great a risk, now are willing to undertake previously unfeasible projects.

The Austrian Business Cycle theory details this phenomenon in greater depth, but whether or not the mechanics of the process works precisely as the Austrian economists contend, clearly this mass initiation of projects and ventures that would have been ill-advised under normal market conditions can only result in disaster.

To illustrate this, take the example of Dumb Ned. Poor Ned doesn't succeed at anything. He isn't logical, organized, or well skilled at any trade. Despite his cognitive shortcomings, Dumb Ned wants to start his own business. Not surprisingly, no lender will provide him with capital he needs (at least not at rates which Ned is willing to accept). However, one of his friends feels sorry for him and provides Ned with an interest free loan, which Dumb Ned jumps at. Not surprisingly, Ned's business fails miserably, and he is unable to repay the loan.

Examining this example, we can observe three things that relate to larger macroeconomic issues — 1) Dumb Ned's venture is too great a credit risk under normal conditions, but Ned is able to undertake his project with a reduced (zero) interest rate 2) Before his business fails there is a period of business activity 3) Ned's friend is never repaid.

Starting with the first point, while this one-time business failure would probably be of little consequence to anyone, what if a number of unsustainable businesses enter the market at once due to artificially low interest rates? Chances are they'd all fail at some point, likely in the same time frame.

The second point helps illustrate the “stimulus” an easy monetary policy encourages. While this business (or multiple business/ventures in the macroeconomic model) may be destined for failure, in the short term there will be an initial flurry of business activity. Office space will be rented, equipment purchased, employees hired, etc. This, however, is only a temporary illusion.

Finally, if Ned or any business goes bankrupt, they will most likely be unable to pay their creditors back in full. In Ned's case, his friend would have eventually received the entire principal of the loan back and have been able to spend or invest it as he felt was fit. In the case of banks, when their debtors default, they are left with only unfinished projects while they lose both their profit from interest payments and the remaining unpaid principal. They are therefore unable to use these resources for more effective purposes. Artificially low interest rates don't eliminate or reduce risk, they only mask over it.

[Note: I recognize that the ABCT and business cycle theory in general are far more complex. Additionally, the interest rate takes into account not only risk factors but time preference factors as well (though there is some debate on this subject). This cursory analysis is only used to indicate the economic disaster fiat credit can result in.]

The complexity of monetary theory only obfuscates the patent absurdity and corruption of our monetary system. While mainstream economics instructs us that inflation is an increase in the price level, which is indicated by a change in various price indices (such as the CPI), price inflation is a result of monetary inflation. Every dollar pumped into the economy is an act of inflation with changes in the price level serving as only one result of this disastrous policy.

Counterfeiting is illegal for a reason. It undermines the value of the currency, and it is effectively stealing. Like theft and murder, however, the state seems to believe the rules that apply to the citizens don't apply to it. Some might protest that it is a different situation when the government engages in theft (taxation), murder (war), and counterfeit (monetary policy). That's true: When the state commits these acts, the results are far more widespread and devastating.

Scott Rosen [send him mail] is a research analyst for a DC area trade association. He is a recent graduate of the Kogod School of Business at American University with a degree in business and economics.

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