Whose Interests Will the Fed Always Protect?

Recently by Gary North: Class Warfare in 2012. Ho, Ho, Ho


Some predictions are easy. Here is mine: “The government of the United States will default on the vast bulk of its debts, which are mainly debts of Medicare, and to a far lesser extent, Social Security and the federal pension system.”

This prediction is easy to make when you have Professor Lawrence Kotlikoff of Boston University doing your research for you . . . free of charge.

He and long-term financial columnist Scott Burns recently wrote an article on the unfunded liabilities of the United States government. The article is based on the figures produced by the Congressional Budget Office. Here is their assessment. Over the past year, the debt of the United States government increased from $211 trillion to $222 trillion. This is the fiscal gap.

The fiscal gap is the present value difference between projected future spending and revenue. It captures all government liabilities, whether they are official obligations to service Treasury bonds or unofficial commitments, such as paying for food stamps or buying drones.

This led to their policy analysis.

Closing the gap using taxes requires an immediate and permanent 64 percent increase in all federal taxes. Alternatively, the U.S. needs to cut, immediately and permanently, all federal purchases and transfer payments, including Social Security and Medicare benefits, by 40 percent.

This sounds good, but neither one will work. I think they know this.

Solution #1 is politically impossible. Even if it were possible, it would create an economic depression. This would not be a fiscal cliff. It would be a fiscal Grand Canyon. This would cut all federal revenues. In a Keynesian-dominated Congress, the government would run a massive deficit. So, a tax hike on this scale is self-destructive. Solution #2 would create a replaced Congress and White House after the next election. Can you imagine Congressmen having town hall meetings after a 40% cut in Medicare and Social Security? They would face a sea of people brandishing canes and shuffleboard sticks.

The authors began their article with this observation.

Republicans and Democrats spent last summer battling how best to save $2.1 trillion over the next decade. They are spending this summer battling how best to not save $2.1 trillion over the next decade.

The politicians came to no agreement in 2011, except to kick the can to January 1, 2013. Then the cuts will come: a grand total of $2.1 trillion over a decade. This assumes that the Congress will not revoke the cuts, which it will probably do. We are facing a recession as it is, with the expiration of the Bush tax cuts – if they are not extended, which they probably will be. In a recession, the federal on-budget deficit soar.

Prof. Kotlikoff and Mr. Burns have shown us that the federal debt conflagration is burning far more brightly than anyone in Congress admits. Second, they have offered solutions that they know, as keen observers of Congressional politics, don’t have a tea party’s chance of being adopted.

Now what?


But not yet.


Congress will kick the deficit can until it is too large and heavy to kick. Then Congress will face judgment day.

How will Congress be able to sell enough T-bills to cover $222 trillion in liabilities? Of course, this will be stretched out over a 75-year period. But, at some point, the costs for the fiscal year will not be able to be covered. Both Social Security and Medicare are tapping into the general fund already to make payments. The general fund is running a $1.2 trillion deficit. What happens when it doubles?

The Congress can grin and bear it for a few more years. But when the public finally says “no more – not at a tenth of a percent per year for T-bills,” interest rates will rise. The deficit will get larger, because the interest rate component will rise. Every year.

Congress can wait for the Federal Reserve to inflate to hold rates down. I think the FED will do this for a while. Then price inflation will come: 5%, then 10%, then 20%. For how long? Until the day that the Federal Open Market Committee says “No more.”

We can and will get mass inflation: low double digits. Mass inflation is not hyperinflation.

Why will the FED stop buying Treasury debt? Because the FOMC, which is controlled by the presidents of the 12 privately owned regional Federal Reserve Banks, will see that any more accommodation will bring hyperinflation. Hyperinflation is bad for commercial banks. Hyperinflation lets borrowers repay loans with worthless money. This is bad – very bad – for bankers.

This is why there has never been hyperinflation in any large northern hemisphere industrial nation that has not lost a major war. Germany and Austria in 1918 lost the war. Hyperinflation came in 1921-23. Then it ended. The currencies were reformed overnight. There was no Medicare. There was nothing like today’s Social Security. There were reparations payments to the victors. The nations borrowed to meet these payments. Then came Hitler and World War II.

Only one nation has had hyperinflation in the northern Hemisphere in peacetime: the state of Israel, 1983-85. In 1985, the policy was reversed. Price inflation went from 445% in 1984 to 18% in the late 1980s and to 1% in 2000.

In Israel, government bonds were indexed to the consumer price index. So, the government would up paying through the nose. Second, not being stupid in financial matters, Israelis began sticking it to the banks. In an article published in 1986 by the St. Louis Federal Reserve Bank, the author described what happened as inflation soared. People borrowed from their banks (overdrafts), and then repaid them with depreciated money at the end of the required time period.

As increased inflation raised the cost of holding money, people began to economize on their money holdings in predictable ways. They changed their payment patterns by matching money closely to their receipts and payments; they increasingly resorted to the use of over-draft facilities and relied more on interest-bearing assets, rather than money, as temporary abodes of purchasing power (p. 26).

Bankers got the message. So did the government. The central bank stopped inflating in 1985.

The government’s bonds were still on the books. The government’s debts remained intact. Lenders continued to be paid.

The government did not escape from its debts. This included retirement payments.

Remember, this was the only exception to the rule: “Central bankers in industrial nations in peacetime in the northern hemisphere do not adopt policies that produce hyperinflation.” So far, legislatures have not forced any central banks to adopt such policies.

This is consistent with my hypothesis:

Central banks adopt policies favorable to large commercial banks. They sacrifice the interests of politicians whenever the politicians’ goals seriously threaten large commercial banks’ goals.


The hard money movement in the United States is presently experiencing a kind of intellectual schizophrenia. First, it has long taught that central bankers favor the goals of large commercial banks. Second, it has also taught that governments will eventually run up debts so large that only hyperinflation can save the politicians’ hides from the voters, by concealing the reality of government default by hyperinflation.

So, the argument has two parts: (1) central banks favor large commercial banks; (2), central banks favor politicians. This two-part argument stretches back three centuries to the origin of central banking: the creation of the Bank of England in 1694. The Bank was privately owned. Its main owners were commercial bankers, mainly based in London. They wanted control over the issuing of fractionally reserved fiat money. They wanted to squeeze out competing banks. So, they made a deal with Parliament: “Grant us this monopoly, and we will buy government bonds at rates lower than what the government would have to pay on a free market.” The Bank would be the lender of last resort.

The Bank has kept its promise to Parliament. It has always been the lender of last resort. But it has never indulged in hyperinflation.

The problem today is this: governments have made political promises that simply cannot be fulfilled. There is insufficient wealth to confiscate from taxpayers. So, the governments will inevitably face default.

The traditional version of the hyperinflation story is that the government will persuade the central bank to inflate. But, because of the nature of the government’s main debts, which are off-budget, these debts will extend for at least 75 years in any given fiscal year. Hyperinflation cannot pay off most of these debts. Yet it will produce huge losses for large commercial banks for several years. The debtors will repay with depreciated money.

Why will the Federal Reserve inflate? If it doesn’t, Congress will have to find ways to cut payments to Medicare. It will squeeze physicians and hospitals. This is obvious. It will then adopt means-testing for the oldsters. Rich people will be cut off. It will finally raise the ages of retirement and Medicare eligibility. This is salami-sliced default. It is still default.


The case for hyperinflation has always been based on ten assumptions, although they have never been listed in one place by any analyst who has predicted hyperinflation. I will now lay them out for your consideration.

1. The nation’s central bank will bail out the national government by buying its IOUs. 2. The central bank will have to resort to hyperinflation to do this: huge deficits covered. 3. The debts of the government will be paid off 100% in the period of hyperinflation. 4. Large commercial banks will not be wiped out by hyperinflation. 5. The interests of large commercial banks and the national government are at bottom the same.

6. Hyperinflation keeps open the doors of large commercial banks and the national government. 7. Hyperinflation must end at some point: currency destruction. 8. There will then be a monetary reform by the central bank. 9. The government’s debts will be gone. 10. Large banks’ balance sheets will be empty, just like the governments’ balance sheets, but the banks will still be in business.

The tough nut to crack is #10. If hyperinflation gets the government (debtor) off the hook to its lenders, how can it be that banks will still be solvent? If the government has had its slate wiped clean, leaving lenders ruined, why haven’t the banks’ borrowers had their slates wiped clean, leaving the banks ruined?

This is not a trick question. This is the heart of the long debate over the issue of who is really in charge: the politicians or the largest commercial banks and their owners?

Those of us who favor a conspiracy view of modern political history argue that what is good for the largest banks is what will be imposed on the voters by the government. We think that the banking cartel is the central power bloc in the USA and the West in general. We think that democracy is the form of civil government, but a banking oligarchy has the final say politically.

We think that when push comes to shove economically, the big banks will be the dominant players in policy-making: first inside the central bank, then inside Congress, and finally inside the executive branch.

There is now a division in the hard money camp. There is no longer agreement on #5: “The interests of large commercial banks and the national government are at bottom the same.” Usually, this is true. But an unfunded liability of $222 trillion points to an inescapable fork in the policy road. The FOMC will have to decide: (1) buy Treasury debt with fiat money up to whatever the government needs to pay old people; (2) keep enough fiat money flowing into the five largest commercial banks to preserve their solvency and profitability.

This is the old political question: Who wins? Who loses?

I have said that Congress may nationalize the FED. In that case, hyperinflation is likely. But if we are talking about Federal Reserve monetary policy, as determined by the FOMC, which represents the largest banks in each of the 12 districts, I do not think the decision will be to hyperinflate.


In this scenario, the primary issue will be this: Will the FED have to adopt hyperinflation in order to keep the largest commercial banks in business? I think it will. The secondary issue will be this: Will the increase in the FED’s monetary base be accompanied by an increase in M1 and a significant increase in the M1 money multiplier? I think it won’t.

If a hyperinflationist argues that hyperinflation will come through a bailout of the largest commercial banks, and that this will ruin the largest commercial banks, this is the argument for short-term salvation bringing long-term damnation. The large commercial banks will die. I have seen no hyperinflationist address this issue. It rests on the assumption that the largest commercial banks cannot default selectively without going under. Therefore, they will call on the FOMC to provide so much money that the banks’ borrowers will pay back the banks in worthless money.

There will still be a currency reform at some point. Then the banks will start over. They will have to start lending. Where will they get money to start over. Hyperinflationists need to address this issue. Who will re-capitalize the largest banks? With what? Accumulated where?

Under a currency reform scenario, the government will still have to default. Hyperinflation will not solve the 75-year problem of the unfunded liabilities of promises to oldsters.

It is clear that there will be a default in either case. It is also clear that the oldsters will be wiped out. It is better for them if there is no hyperinflation. Hyperinflation will not save them. They are on fixed incomes. Social Security’s cost of living adjustments will be delayed until the following fiscal year. Too late!


The Federal Reserve’s primary task has been the same ever since 1913: to protect the interests of the largest commercial banks. It has faithfully done this. Whenever a large bank was allowed to go under, its assets were transferred to an even larger bank.

No large commercial bank went under in the Great Depression. But 9,000 small ones were allowed to fail until the FDIC was created in June 1933. When banks failed, the bankruptcy courts allowed large banks to buy the assets of insolvent banks at a discount.

Big fish eat smaller fish. The biggest fish run the Federal Reserve System.

The Federal Reserve will use its legal authority to create digital money to guarantee the survival of its regional branches’ owners: the largest commercial banks.

The New York FED, alone among the 12 regional banks, has a permanent vote on the FOMC. We can infer which banks will always be protected: those large commercial banks that are inside the district of the New York FED.

The Federal Reserve will inflate enough to keep large banks solvent. It will not inflate whenever hyperinflation threatens to enable borrowers from large banks to repay their loans with worthless money. Then it will stop inflating.

It will not buy Treasury debt at that point.

We will then see if Congress nationalizes the FED.

August 25, 2012

Gary North [send him mail] is the author of Mises on Money. Visit He is also the author of a free 31-volume series, An Economic Commentary on the Bible.

Copyright © 2012 Gary North