Wednesday, May 06, 2009

Inflation, Deflation, and the Federal Reserve

The U.S. spent close to 100 years in the 1800's without an effective central bank. These years were exemplified by a constant cycle of inflation and deflation that served to strip wealth from the debtor class (i.e. people like you and me) and transfer it to the creditor class. This was caused by fractional reserve lending and the business cycle. As the business cycle went up, banks expanded their lending and thus created inflation by reducing their reserve ratio (the money supply increases as an percentage of the banking system's overall reserve ratio). As the business cycle went down, banks contracted their lending and thus created deflation by increasing their reserves in case there was a run on their bank by people who'd lost their jobs and needed their money. And if the bank was hit by a lot of defaults on its loans because deflation rendered the loans unpayable, so that it could no longer sell its loans on the open market to other banks in case it needed cash to deal with a bank run (or worse yet other banks or investors refused to buy the loans because they too were preserving capital), then banks collapsed, causing even more deflation and more economic misery as everybody with money in that bank lost it.

This happened while the U.S. was on a "hard metal" standard, so Ron Paul's idiotic call to return to the gold standard won't resolve it. Only banning fractional reserve lending would resolve it, and that would kill the economy because fractional reserve lending is how the capital equipment that produces future income is purchased using current income. Without fractional reserve lending you basically do not have banks and the amount of capital available for lending implodes dramatically. That is, in a mildly inflationary environment where virtually all capital is in a bank at any given time (since that is where you earn interest, as vs. mattress stuffing where your money loses value), your economy can leverage the capital of the entire nation as backing for bank loans that produces future economic output. And bank loans are also important because bank lending allows the capital expenditures to respond to future demand using the future income generated by that future demand, and thus allows a capitalist system with functioning banks to be far more flexible and nimble at meeting consumer needs than a system without functioning banks. Without functioning banks, you must wait for capital to slowly accumulate before you can make the capital investments needed to meet new needs... which slows economic activity drastically over a modern economy with a functioning fractional reserve banking system.

Okay, so the gold standard won't work at solving these inflation/deflation cycles as long as we have fractional reserve lending, and we can't ban fractional reserve lending without basically knee-capping capitalism, so now what? Well, we could hypothesize a central bank that could print money during "down" cycles to replace the money that's being lost as banks contract their lending, and that could *unprint* money during "up" cycles to keep excess inflation from taking hold. By carefully adjusting the money supply up and down, this hypothetical central bank could keep the money supply growing at the slight amount of inflation needed to keep most capital in the banking system (and thus available to leverage for future economic activity). In addition, this hypothetical central bank could buy loans from banks hit by bank runs i.e. serve as a lender of last resort if necessary to prevent banks from collapsing. That prevents the stripping of wealth from people who have money in banks.

There is only one problem with this scenario: It had been tried multiple times before, and the result was almost always disaster. The core problem: Governments, given access to a printing press, are almost compulsively driven to print money to meet their financial needs rather than raise taxes to meet their financial needs. And there is only one end game there -- hyperinflation, which is a disaster of *another* sort for the economy because then banks once again cannot serve as an instrument of leveraging current income into future economic activity, because people yank their money out of banks to spend it as quickly as possible before it becomes worthless.

So it is clear, then, that putting a central bank with the power to print money under the direct control of the U.S. Congress or of the President is a bad, bad, bad, BAD idea. The notion that they could long resist the impulse to print money rather than tax the general public to pay for the government's expenses simply doesn't pass the laugh and giggle test. So if it cannot be under the direct control of the President or Congress, then what?

So the general scheme arrived at was to put some of the control in the hands of those entities that have the most to gain from a stable (but slightly inflating) money supply: Banks. Thus banks are the shareholders of the Federal Reserve Banks and appoint 2/3rds of the board of directors at the Federal Reserve Banks. But then there would be the temptation to manipulate the money supply to benefit bankers rather than the public as a whole, so the overall Federal Reserve System was given a board of governors appointed by the President with staggered 14 year terms (to insure that no single President could overly influence the board) with the consent of the Senate and with the final power to determine the money supply. In short, that's today's Federal Reserve, which is a bizarre setup, but it's a bizarre setup for a reason -- it's a work-around to two major problems, the first being inflationary-deflationary cycles caused by fractional reserve lending and the normal business cycle, the second being hyperinflation when government itself has the power to print money.

So there you go. It sounds all so prosaic now that you see where the Fed came from, why we need it, and why it's set up the bizarre way it's set up rather than as a direct federal agency. As for the natterings of gold bugs and conspiracy theorists? Well, what can I say... some folks' tin foil hats just need adjusting.

-- Badtux the Monetary Penguin


  1. Some Loony Leftie named Glenn Greenwald says why the Federal Reserve needs to be audited.His last sentence: "Who opposes an audit of the Fed's activities and why?" That Loony Leftie -- agreeing with Ron Paul's bill. What a bunch of crazy people! Obviously not the Serious types who recognise that the rich and intelligent banker/politicians know exactly what they're doing, and will always do what's best for us Little Folks.

  2. Badtux, did you happen to see this article?

    The Ron Paul phenomenon, Part 1: Evaluating the message
    By Geraldine Perry
    Online Journal Contributing Writer
    May 7, 2009, 00:26

    "...At the same time Paul was able to tap into the opposite end of the political spectrum by calling for a repeal of the 16th Amendment as a means of ending the income tax, and limiting government spending. Herein lies a conundrum because (rightly or wrongly) not only are the peace groups unlikely to support strictly limited government spending -- except insofar as reigning in war and militarism are concerned -- but a fair study of the income tax issue makes it clear that the Sixteenth Amendment did not grant the federal government any new taxing power, nor is it the source of the federal government’s power to impose income taxes. [1] [2]..."

  3. Bukko, Greenwald is not an economist and furthermore, Greenwald's own ideological biases see nothing wrong with giving government itself the power to print all the money it wants to print, because like the loony right they confuse money with being wealth (it's not -- money is just a token of exchange, it's the assets you *buy* with money that are wealth). I.e., the radical left believes that the way to make Americans more wealthy is to just print more money, and then Americans will be wealthier.

    The Federal Reserve is in fact audited by the General Accounting Office, and has been so since 1978. There are certain areas that are off limits to the GAO, and open market operations are one of those because of the concern that allowing too much government oversight of the fundamental task of the Federal Reserve -- that of printing money -- will lead to a compromising of the Fed's independence when it comes to managing the money supply and thereby inevitably, history says, hyperinflation is the result. But the notion that there is no accountability at all at the Federal Reserve is utter nonsense. The member banks can, and do, audit the Federal Reserve regularly using private accounting firms because it's their fees that fund the Federal Reserve and they are officially the owners of the Federal Reserve. The Board of Governers, which, remember, is appointed by the PResident, also can and does audit the Federal Reserve regularly using private accounting firms. So this isn't a case of the Federal Reserve not being audited. This is a case of certain parts of the Federal Reserve -- the parts related to the creation of money -- being currently off limits to the GAO (but audited by both the banks' auditors and by the Board of Governors' auditors) out of fear that this would be the camel's nose that led to a loss of the Fed's independence and thus, inevitably, to hyperinflation and the death of the U.S. dollar as a credible currency.

    And if you now start nattering about a Jewish conspiracy of bankers blah blah blah... Uhm, no. This whole setup was deliberate, and configured to try to account for the self-interest of the various parties to keep each party from taking advantage of the Fed to enrich itself at the expense of others. Thus Congress is not allowed to control open market operations because that would allow Congress to enrich itself at the expense of a stable currency (i.e., at the expense of the banks and businesses that need a stable currency in order to conduct business), the banks are not allowed to control open market operations because that would possibly lead to them steering those funds their way, and otherwise there is a complex set of checks and balances here that has been built up over the years. Destroying the Fed's independence is in the best interests of no one -- not you, not me, no one -- because the end result of doing that will be the destruction of the U.S. dollar as a credible currency. Having talked to people who saw this kind of thing happen in the past, such as a Russian office-mate who saw turnips become the de-facto currency of Russia after the collapse of the Soviet Union and an elderly grandmother who saw teachers being paid in eggs and milk by the county during the Great Depression because all currency had disappeared under mattresses and the county could only collect goods in lieu of taxes because there literally was no money to collect and a tax sale would not have brought in any money either because nobody in the whole county had any money, I have a keen awareness of just how important a stable currency is to economic activity. If you don't have a stable currency, the economy grinds to a halt. It happened during the Great Depression, it happened during the collapse of the Soviet Union, it happened in Weimar Germany, and it could happen here if we muck too much with the Fed and give Congress too much control. The temptation for governments to just print money on demand is just too much, history shows, for the currency to last long past that point.

    - Badtux the Monetary Penguin

  4. Then thank goodness we have hard-nosed federal officials in charge of overseeing Teh Fed's activities, like the kick-arse, take-names woman in this YouTube. She sure shows the Loony Lefty Congressman that she's on top of things when he starts asking her about tinfoil hat stuff like Teh Fed's "off balance sheet transactions". Nothing gets past that gal, nosiree!

    Do you think I characterise the conspiracy of bankmaggots as a Jewish one? To say that rich bastards are gaming the system to loot as much as they can get away with does not imply anything Jewish. Some may be Jews, most are Christians, there may be Muslims (hi, Saudis!), putative communists in China and atheists. The Magical Sky Being they do or do not believe in is of no import. What they really worship is money, because money is power.

    But hey, I'm a Loony Lefty. I should concede that everything's gonna be just fine. Nothing to see here folks, move along. No looky-lous.

  5. Dude, I have no idea why you trust politicians any more than you trust bankers. Giving either politicians *or* bankers all the power in the Federal Reserve would result in disaster.

    Luckily, as I pointed out, the Fed's governance gives *neither* all the power. Indeed, Ben Bernanke is an economist, not a banker, and not a politician. The Fed's independence from control by either bankers or politicians is sometimes an iffy thing, but is a goal that must continue to be pursued because history shows that if you allow the central bank to be controlled by either group, the result is typically a monetary disaster.

  6. I'd settle for the Fed to be controlled by some HONEST politicians. Pollies who were working for the best interests of the whole of the American population instead of their own job security (see Arlen Specter) or their campaign bribers (see every mangy blue dawg DINO). Surely we can get some of those.

    Then the job of the angry, active American people is to keep them honest. If all that can't be done, the U.S. is toast. As I see it, I'm gonna win either way. I got a comfy place in the cheap seats and lotsa popcorn.

    Tux, I say you need to get more cynical and paranoid. Trust no one! Have you ever checked out a blog called "The Automatic Earth"? The guy (I assume he's male) behind it is mostly a compiler of articles and stat-laden opinion pieces from various semi-obscure, wonkish publications. He's somewhat of a doomster, but not one who revels in it. Imagine if Eeyore the Donkey had an econoblog. I've been expanding my viewpoint based on the voluminous stuff there.

    That reading reccy goes for you too Nunya! As if you don't have enough to plough through already.

  7. What's more cynical and paranoid than thinking that giving a printing press that prints money to politicians is like giving whiskey to a drunk? Bad, bad idea, and we've had plenty of proof of that over the years. Are you saying that the European Central Bank is part of some giant conspiracy against America too? Because it was set up in pretty much the same way as the Fed, which is irritating European governments to no end right now because they want to print, baybee, print, and the ECB says "Nein!".

    Which just goes to show that even Europeans now know better than to put a printing press into the hands of politicians...

    - Badtux the Cynical Penguin

  8. Thanks for a well-written post on an agency that's misunderstood (at best). I'll bide my time and impress the hell out of somebody who brings up the Fed. Hope they don't wait too long. I'm forgetful in my old age.

  9. Guilottine man14/10/09 11:56 AM

    Answer this than.Who owns Federal Reserve today and have been since Jackel Island.

  10. The Federal Reserve is an independent entity within the U.S. government. See the above for a complete description of its ownership and governance and why it's done that way, duh.

  11. Guillotine Man16/10/09 1:17 PM

    You left out PRIVATLY OWNED ENTITY within US government.It is not part of the government so who is it's master.Who controls Federal Reserve.Why don't you watch the documentary Money Masters than try to answer Who controls Fed.

  12. I answered that question above. I'm sorry that you want to peddle deranged conspiracy theories rather than read my factual analysis of how the Federal Reserve is set up and governed and why it is set up and governed in that way, but so it goes. Next thing you're gonna be talking to me about is how Obama is gonna set up death camps for all Republicans, or some stupid shit like that? GAH! The Crazy, it burns it burns!

    - Badtux the "Where do these loonies come from?" Penguin


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