Of late, the FED has been inflating the currency more than its usual degree. The FED is intentionally depreciating the value of the dollar, which is the same as saying that it is raising the prices of various goods and services.
The FED knows that it is inflating. When the FED announced a large purchase of securities on March 18, 2009 at 2:30 p.m., the dollar dropped immediately and gold rose, by large amounts. An instant devaluation of the dollar occurred. Of these effects, the FED is completely aware.
The official aim of the FED’s inflation is to reduce unemployment. The FED has a dual federal legislative mandate: price stability and full employment. In periods of high unemployment, the FED speeds up its usual inflation of the currency in an effort to reduce the unemployment. That’s the official story.
The official mandate spells out the FED’s legal or de jure framework. The FED’s actual or de facto activity is to inflate 90 percent of the time. In boom times, the FED inflates. In periods of moderate unemployment, the FED inflates. During periods of war, when unemployment is not high, the FED inflates in order to support the bond issues of the federal government. From 1918 to the present, there are at most a handful of brief periods, lasting perhaps 10 years in total, in which the FED did not inflate the currency. The FED was set up to inflate, and that’s what it does. And, by the way, there is no other cause of inflation but the FED.
My theory is that the FED was set up to inflate in order to benefit member banks. By inflating, the FED provides member banks with free reserves that are the source of low cost deposits. The banks obtain this "raw material" cheaply and without much competition. They profit by using it to make loans. The FED’s real objective is not price stability but bank profitability.
Only rarely does the FED have a leader who is tight-fisted with bank reserves or looks to the long-term interests of the banks by regulating the amount and composition of their loans, and then only for short periods of time. The FED hardly ever stems a boom in the bank lending that it stimulates until it has to, and then it brings on a recession. The economic effects of the FED’s inflation are incidental to its overriding objective, which is the welfare of member banks.
As for unemployment and the economy, the FED has no demonstrable loyalty to, affection for, or goodwill toward the American public. Nothing that it does to the currency has ever shown concern for Americans in the slightest. If the FED actually cared about the welfare of Americans, it would maintain a stable currency so that people could contract and preserve wealth without worrying that the unit of account would lose value. The FED has never done this. Consequently, a person who holds wealth loses a large share of that wealth to confiscatory taxes. A person who bought an ounce of gold for $100 in 1959 and sells that ounce for $1,000 in 2009 (because the FED has devalued the dollar) must pay a tax of about 28 percent on the phantom capital gain. If the FED actually cared a whit about the American people, it would maintain a stable currency and thereby moderate the advent and extent of periodic booms and busts.
The FED’s very existence attacks the public welfare. The FED serves only bankers and the federal government, and the latter only because it must. To the extent that inflation ever temporarily changes employment, it is incidental to the FED’s goal of maintaining or building up bank profitability.
Government support for the FED as a national institution is unswerving. The federal government has replaced the Bill of Rights with a Bill of Goods promised and sold to the public, every item of which is false. A superstructure of court economists constantly rationalizes this false Bill of Goods.
Among other false items, which are too numerous too list in their entirety:
- The federal government in Washington is an essential agent in providing economic security and stability for the country as a whole. False.
- The entire economy of the country can be beneficially manipulated through macroeconomic policies devised and executed in Washington. False.
- Americans cannot be trusted to operate the price and market system on their own. They need constant supervision and regulation (from Washington) of almost every element of economic activity. False.
- The economic activity of Americans needs constant correction and adjustment by Washington (as to consumption, saving, employment, interest rates, investment, production, credit, liquidity, mortgages, etc.) False.
- Americans cannot be trusted to produce money and credit on their own. They need Washington to do this. False.
- The country’s economy is unstable and needs constant control and guidance from Washington. Otherwise, recessions and unemployment occur that Americans cannot themselves correct. False.
- Economic stability requires an overall monetary policy stemming from Washington. False.
- Americans are unable to produce a stable price level (to the extent that such a thing is measurable). They need the FED to do this for them. False.
- Maximum employment is a socially optimal objective. False.
- The federal government and the FED do not create economic instability and insecurity. False.
- The federal government and the FED are capable and adept at moderating and alleviating economic instability at little or no cost. False.
- Exceptional performance of the economy, when it occurs, is due to the skill and wisdom of Washington’s economic policy makers who successfully manipulate Americans into behaving in their own interests. False.
- The FED has had success in producing price stability and moderating the business cycle. False.
The FED’s rationalizations for inflation change over time. The FED creates new myths continually. In the last year, the FED has pushed three myths.
Myth #1 is that its inflation offsets the negative economic effects that are occurring. Their theory is that the costs, if any, of inflation are lower than the benefits.
Not only is the Austrian analysis directed squarely against this myth, but even in one FED research paper, a 4 percent inflation is estimated to cost 1 percent of output per year! Another paper finds significant output and utility losses from inflation and concludes "The optimal level of trend inflation is zero." Conventional economists are waking up to the negative effects of inflation.
The current depression would not have occurred without the FED’s inflation. Professor John B. Taylor’s paper is highly critical of the FED’s inflation from 2001 to 2005. Coming from a non-Austrian and being highly readable, it is all the more helpful in making the case against the FED.
Myth #2 is that the FED’s loans offset economic problems by providing liquidity to the private sector and supporting credit extensions.
The fact is that the credit markets would be a whole lot healthier without the FED. The market participants would stop over-leveraging. They would evaluate risks more appropriately. They would have to provide greater transparency in order to attract capital. There would be greater competition. Illusions of liquidity would disappear and the true costs of liquidity become apparent. To the extent that the FED’s loans are based upon good collateral (which the FED emphasizes in the case of primary dealers and banks), the FED is crowding out private lenders. To the extent that the FED is discounting loans that have poor markets or have questionable value, the FED is sustaining lending and institutions that deserve to be under pressure.
The entire thrust of FED policy as geared to liquidity is questionable. The banking problems center on bad bank loans and the reluctance of lenders to roll over short-term loans to banks whose assets are questionable. Like the TARP loans, the FED loans cannot resolve these problems. They have prolonged them by removing the incentive for banks, which otherwise would have been under greater market pressure, to resolve them. These loans have simply replaced private market capital that might have been supplied under more stringent conditions that would have forced the banks to face the problems and deal with them.
Myth #3 is that the FED promotes systemic stability by supporting such institutions as AIG, Citigroup, Fannie Mae and Freddie Mac. They deliver this line with a straight face. All of these should have been allowed to fail. The latter two companies are at the center of the entire housing debacle. They should even now be allowed to fail. They supported the packaging of mortgages into securities. They supported the movement of banks away from servicing mortgages and into originating and distributing them. They supported lending to poor credit risks. At the moment, they are Congressional vehicles for reflating another housing bubble. The less said about AIG and Citigroup the better.
Inside Myth #3 is the hidden Myth #4, which is that a free market economy gives rise to companies that pose systemic risks. Myth #4 justifies state socialism by the notion that there is an externality that the government can and should deal with.
According to this myth, a systemically large company (as judged by the government bureaucrats) has a public character, because it affects a large swath of the economy. This notion assumes that individual players cannot and do not take into account the risks of dealing with others whose behavior may affect them under certain circumstances (which is what an externality means). It assumes that people who risk large amounts of money are too stupid to protect themselves. The fact is that a major entrepreneurial function is to assess risks, structure assets and liabilities, structure contracts, and structure hedging and insurance, so as to cope with risks of dealing with others. When this is not done, it is because the government has introduced a guarantee that elicits moral hazard (sloppy assessment of risks and excessive risk-taking). When the size and risk structure of companies is established in a free market, entrepreneurs will be taking into account their risks of dealing with others to the extent that it pays them to do so. If they under-estimate and they lose when a major company fails, they will learn. They will iterate toward a better solution. By the way, some large banks failed in the 1800s during various panics. The markets rebounded and people learned how to cope with such events. The market took care of these systemic risks.
Externalities pervade human relations. Assessing uncertainties and dealing with them is a basic entrepreneurial function. The question is in what setting people handle them best. The answer is that people look out for potential risks and losses best when they have a lot to lose. This is not the case with government bureaucrats and politicians.
Myth #4 concludes by saying that the government has an interest (on behalf of the public) in supporting the systemic company when it has troubles. This is the "too big to fail" doctrine. Anyone who swallows this must have been reading the funnies his whole life.
No part of Myth #4 is true, and every part of it is inconsistent with a free market economy. Either one has a market economy or one has state socialism or fascism. There is no middle ground, for the reason that when the government becomes a player in any given market, the fundamental character of that market disappears. The character of innovation, pricing, employment, location, labor relations, product development, marketing, etc. all alter. The entrepreneurial element is shifted toward playing politics.
The FED’s official theory currently consists of the myths just outlined. Behind these lie the false items in the Bill of Goods sold to the American public. The FED’s actual theory, which it practices constantly, is to inflate the currency so as to benefit the member banks.
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.