A great deal of putative middle-class wealth has evaporated in the current financial crisis. Unless you cashed out and put the money in precious metals or in the mattress before the current financial crisis began, it is gone forever. As for what remains, we are in the process of being further subordinated to huge commercial interests, and are already locked in to a severely declining standard of living. It is increasingly unlikely that we are going to have a comfortable retirement with relative economic peace of mind. It is increasingly likely that many of us will be wards of the state, dependent upon social security and Medicare. Such as they will be, in a decade or so.
In this article I want to explain, with reference to a few simple economic factors, how this happened and why our remaining wealth is neither going to be restored nor grow — unless and until certain fundamental changes are made. Specifically, we need to eliminate the Federal Reserve System. This is one of those topics that gets you quickly dismissed in American politics as a complete nutburger, but it is my hope that I can explain this with reference to such familiar experience that it will become apparent why the Federal Reserve System is a key factor in our current predicament.
Middle-class wealth resides predominantly in college and retirement savings. (I exclude homes because homes are a consumable good, not an investment). These savings are incentivized through tax exemptions but at the price of restrictions on use and penalties on early withdrawal. As a means of increasing future wealth, this program of "saving for our future" has now been proven to be largely ineffective, if not completely illusory. Pre-crash investment wealth is not coming back, and any increase in nominal value will reflect inflation (i.e., a decrease in the purchasing power of the dollar) rather than a real increase in value. The government’s polices guarantee that we will have no real investment growth for a very long time. This will not change unless and until the Federal Reserve is eliminated.
You have noticed that, for a long time now, at least since the Savings and Loan crisis of the late 1980s, banks do not pay any real interest on your money, that the rates they offer rarely even approximate the annual CPI rate, let alone the real rate of inflation. Dollars left sitting in a savings account or even in a timed deposit like a certificate of deposit, are actually just losing value. This is because (i) by law, only U.S. dollars are legal tender within the United States, so that all other currencies are excluded, and (ii) the supply and cost of credit is controlled by the Federal Reserve.
The first factor is relevant because the Federal Reserve’s power depends almost entirely on the fact that it is a private cartel that controls a legal monopoly over money. Were all currencies, or even some moderate number of currencies of other nations or financial institutions acceptable as legal tender, the Reserve would face competition that would compel it to act more responsibly. If every person could designate the form of legal tender in which he was to be paid, currencies that better preserved value would be favored over currencies that did not. For example, a short time ago, when the dollar was quickly depreciating against the euro, there was a news story that merchants in New York City were putting signs in their windows for the European tourists flocking to the city because of the favorable exchange rates: "Euros accepted here." By accepting euros, the merchants were acquiring a currency that, relative to the dollar at that time, actually enhanced and preserved their purchasing power. If every employee, every person could, day to day, state that he was accepting payment only in euros, or yen, or Swiss francs, or (oh no!) gold and silver, the continual risk of flight from the dollar would impose discipline on the Reserve or, in the absence of the Reserve (which in truth would then have little reason for existing since it could not reap the benefits of a legal monopoly), the Congress.
The Reserve has two powers pertinent here. It can create credit by fiat (more colloquially, "print money"), and it can set the rate at which it will extend this credit to other banks for use by those banks. Essentially, banks are not willing to pay you anything, or much, for the use of your money because the banks can get boatloads from the Reserve and can get it dirt-cheap. Right now, the federal funds rate is 0.25%. The Reserve is essentially giving it away for almost nothing. Even a year ago, the rate was only 3.5%. The ability of banks to obtain cheap, seemingly unlimited credit from the Reserve devalues your money and, here’s the key, actually prevents your money from participating in the making of money. It prevents you from benefiting from being a capitalist with your own funds, however limited they may be. You cannot grow your own wealth by making it available to productive enterprises. The Reserve shunts you out of growth of your money through savings and investment because it can always provide vast sums of money more cheaply than investors.
The Reserve’s control of this legal monopoly over legal tender and credit relegates you, permanently, to the status of a consumer. By providing no financial incentive to save, and by actually penalizing saving through deflation in value of the dollar, the Reserve creates an incentive to spend all available funds as received. This benefits commercial interests that cater to consumption, and the financial institutions that provide credit for that consumption, creating additional profits for those companies that would otherwise be lost if a portion of your discretionary income were saved and invested in production rather than spent on consumption or debt service for past consumption.
Okay, forget about saving. What about the stock market? We don’t have to save, we can "invest" our funds in stocks, and our "investment" can grow over time. Right? That’s why we’ve all been diligently funding our IRAs and 401ks.
Thanks to the latest financial crisis, we now know the answer: No. It’s the same as with saving, because the Reserve’s unlimited supply of cheap credit also makes stock irrelevant. While this has long been the actual predictable result of the Reserve’s operations, it is now apparent from the news on the nation’s business pages. From the time of the dot-com bust in the 1990s until the recent financial crisis, stocks were essentially going nowhere, simply oscillating within a range, and they have now lost substantial value. In 2008, the Dow Jones Industrial Average fell 33.8%; the Standard and Poor’s 500 Index fell 38.6%; and the Nasdaq Composite Index fell 40.5%.
The reality is that companies almost never issue public stock to raise capital for their businesses. There are two powerful reasons for this. First, companies can get credit from banks via the Reserve cheaper, easier and with lower transaction costs than they can get it from investors. The Reserve undercuts investors in favor of financial institutions. Secondly, the payment of interest on debt is a deductible expense for income tax purposes, while dividends (payments on capital) are not, so that the after-tax cost of debt is even less than nominal interest rate charged.
The tax advantage alone is a nearly insuperable incentive to fund business expansion with debt instead of equity. The U.S. corporate income tax rate is a minimum of 34% for taxable income in excess of $100,000. At this rate, the after-tax cost of paying a 10% return on $10 million in capital is $1,515,152 ($1,000,000/.66), and of paying a 10% return on a $10 million debt is $660,000 ($1 million—$340,000 tax benefit). Combine the tax incentive for debt financing with cheap credit from the Reserve, and the economic system is overwhelmingly skewed in favor of minimizing capital investment and maximizing debt financing.
Note that the effect of these systems is to shunt profits away from investors in productive enterprises to the payment by productive enterprises of interest to financial institutions which, nota bene, themselves require little capital because of the nation’s banking laws and Reserve’s unlimited cheap credit. This system is a bankers’ dream come true because it maximizes the borrowing of money. Unfortunately, the moral hazards of (i) such a near complete supplanting of capital and, (ii) (thanks to the Reserve’s legal monopoly) interest rates untested by competitive market pressures and hence dissociated from reality, virtually guarantee an ultimate crash. It is hard to imagine a system with a greater built-in predilection for boom and bust.
Please note one other effect of this system that ought to concern everyone besides lenders. Dividends do not have to be paid when money is not available, and investors in common stock are not secured creditors. Interest, on the other hand, does have to be paid, and banks have security interests on assets, and will foreclose if not paid. Accordingly, a company that raises capital to finance its expansion and activities is better able to weather financial vicissitudes than one that has financed itself with debt. Since debt must be paid, the effect is that, in a downturn, the company, to survive, must act quickly to reduce its labor costs. As between the two forms of financing, debt financing guarantees that a company will seek to minimize its business losses by firing workers. In other words, debt financing essentially guarantees that there will be greater and more rapid job losses in an economic downturn.
The moral of the story? If we get rid of the Reserve, we get rid of an institution with the power to undercut all investors and to provide cheap credit divorced from economic reality, and if we also get rid of the tax bias in favor of debt financing, then companies will have a more rational balance of capital and debt, investors may again be able to make money on their money, and companies will have a greater ability to hang on to workers, who they will need when business picks up again.
Back to those 401k’s. Since, thanks to the Reserve’s low interest rates and our tax policy, companies essentially no longer raise money by selling stock publicly, there is a relatively fixed pool of public securities in which all persons seeking to invest may invest. The investment demand far exceeds the supply. As a result, stocks become "overvalued." That is, the price per share becomes primarily a function of the large demand, and the huge amount of capital seeking to invest in the same relatively fixed group of assets, rather than a rational reflection of the income stream from the shares or even their companies’ liquidation values. Before the current financial crisis, shares traded at multiples of earnings unheard of even two decades before.
In other words, courtesy of the Reserve and tax policy, (i) stocks are not a real economic growth opportunity, but are, instead, (ii) a demand bubble that will eventually burst, at a sizable loss disproportionate to the actual decline in the company’s revenues or decline in liquidation value.
It should be apparent from the foregoing that the Reserve’s current policy of reducing the federal funds rate to practically zero and the government’s bailout of banks and other financial institutions by providing capital to offset their losses is an attempt to protect the preferred position of the banks. It should be equally apparent that this policy will only deepen and prolong the crisis, by further shunting any and all other capital, including the savings of the middle class, from participation in economic growth and development. The purported goal of shoring up the banks is to once again get credit flowing (i.e., generating continued profit opportunities for banks through even more borrowing), which supposedly thereby indirectly benefits the rest of us through business expansion and renewed personal consumption. This is a trillion dollar trickle down theory to end all trickle down theories! "Reaganomics" never dared to dream on this scale!
So long as the Reserve is running the show, your money will have no place to participate in and profit from the economic growth of this country. Your place will be to spend your money to make profits for others, particularly banks. There is simply no reason we should stand for this or play along. We need an end to the Reserve as well as changes in tax policy to eliminate the economic disadvantage imposed upon capital relative to debt. As I hope I have made clear, bringing back capital (and eliminating debt) permits everyone’s savings to participate in real economic growth, instead of in illusory demand bubbles, enables businesses to better weather economic downturns and protects more jobs. These elementary facts are ignored because our country’s policy is to protect and benefit banks, through policies that maximize debt financing using monopoly money. Hey Congress! How about the rest of us? Remember us, the people you supposedly serve? Bring back capital!
Jeff Snyder [send him mail] is an attorney who works in Manhattan. He is the author of Nation of Cowards — Essays on the Ethics of Gun Control, which examines the American character as revealed by the gun control debate. He occasionally blogs at The Shining Wire. Read this interview with him.