Chapter 4: The Central Bank Controls Booms and Busts
- Louis McFadden, US Congressman (R-PA) (1915-1935), Chairman of House Banking and Currency Committee
A History of Money
Booms and busts in the economic cycle occur naturally. However, that does not mean they have to be devastating. According to Alan Greenspan, the economic cycles before WWI were relatively tame compared to today’s cycles.
Periodically, as a result of overly rapid credit expansion, banks became loaned up to the limit of their gold reserves, interest rates rose sharply, new credit was cut off and the economy went into a sharp, but short-lived, recession… Compared with the depressions of 1920 and 1932, the pre-World War I declines were mild indeed.1
Therefore, it is important to note that the limit of credit acts as an important regulator of the economy. It also prevents the government from going too far into debt as a result of welfare systems or wars.1 The central banks of today do not have limits on credit and therefore do not have limits on the amount of debt they can incur.
It is also of interest to note that the current Federal Reserve Bank, enacted in 1913, is not the first central bank in the US. Three previous periods saw the creation of central banks, and in each of these cases, the banks failed for the same reason. To improve liquidity needed for either war or welfare programs, the banks ran the printing presses. In each case, the value of the notes they printed either fell to zero or were significantly devalued.2
The term “greenback,” coined during the Civil War, is used to describe our dollar today. In order to pay Civil War debts, the Union Treasury ran the printing presses so quickly that they did not bother to print both sides of the bill in color. Only the backs of the bills were green. The eventual value of those notes was zero, as in other previous issuances of US paper money notes.2
Governments inflated their currencies before the use of paper as currency. Before nations printed their money, they used coinage. In the days of goldsmiths, people would seek safe haven for their coins. It made sense for people to deposit the coin with the goldsmiths, who had the best security due to their occupations.3
In exchange, the goldsmith would issue a paper certificate with a promise to redeem it for gold at a later point in time. Goldsmiths also noticed that if people felt their money was safe, they would leave it in his vault. Therefore, in an early form of fractional reserve banking, goldsmiths issued additional paper certificates in excess of their actual gold holdings2 These certificates were considered very reliable and were often used as an early form of paper money. The bearer could trade the certificate for goods, and the holder could travel to the issuing goldsmith to redeem the note for true gold.
These certificates were not legal in the realm, but as long as people did not redeem all of the notes at once, goldsmiths could get away with it. This early version of credit earned the goldsmith additional fees. However, the kings soon realized the advantages of using paper money that was not entirely backed by actual coins. Goldsmiths began issuing paper certificates in increasing numbers to governments, which used them to pay for wars and supplies. Eventually the system overheated and the paper certificates defaulted.2
Another form of currency debasement was popular during Roman times. Rome’s economic collapse is a major reason for the demise of the empire. When Rome could no longer support their armies and workers using money, the Empire began to decline. Roman emperors did not use paper currency. Instead, they would shave off the edges of the gold coins for melting into new coins. In other cases, they would combine less of the precious metals with the gold and silver. Often they did this without informing the people, which increased the amount of coinage in circulation and caused inflation.
Debasement of Roman coins could only go so far before merchants discovered the coins didn’t have the same shape, weight, and color. It was only the threat of jail or death that forced the people to continue the use of debased coins as if they had the same value as pure coinage. Because the gold currency was not allowed to function as a check on spending, but was instead subjected to Roman government devaluing, the Empire was allowed to expand too far and eventually declined when it could not support itself. If the government had not debased the gold currency and had allowed the natural process of money supply and demand to regulate the markets, one wonders if the unbridled expansion of the Roman Empire would have continued to take place. It is possible that the Roman Empire, though smaller, may have remained solvent for much longer than it was.
This picture shows a Roman Antoninianus made of Copper with silver coating. Note the shaved edges.
This shows an American quarter, with beveled edges. After 1969, the US mint stopped using real silver in coins.
The shaved texture on the rim of coins is still found on US issue coinage, as an apparent homage to this historical government coin debasement technique.2
In fact, to honor coin debasement, the United States stopped minting silver coins after 1969 and now prefers nickel and copper. More abundant and worth less, these metals devalued US coins in much the same way printing presses are used to devalue the paper currency we use.
Modern Money Creation
So why is it that we support a system with a central bank, known as the Federal Reserve? The reason the central bank exists is to increase the power of Congress and the wealth of bankers.2
Congress begins the process by issuing debt, which is then purchased by the Fed. Does the Federal Reserve, which purchases the debt from the government, have any money to buy the debt? No, they don’t. The government doesn’t cash the check from the Federal Reserve Bank. They simply endorse it and deposit it into one of the member Federal Reserve banks where it becomes a deposit. With this “deposit,” created from a debt backed by the government with no previous ability to pay, the government can now write checks to pay the bills.2
Once the money spent by the government is in the market, it is deposited into commercial banks by the receivers. When commercial banks receive deposits, which are actually liabilities to the depositor, they are classified as “reserves.” Reserves are assets which can be lent against. Through fractional reserve banking, new money is then lent at a rate of nine times assets. Let us look at an example for clarification.
Let us say that the banks pay 1% interest to acquire a debt asset worth $1 million. At the end of the year, the bank’s cost to lend this asset is $10,000. The bank lends $9 million to the public, at an interest rate of 5%. Their revenue from this lending is then $450,000. Revenue minus costs equals a profit of $440,000!
The original debt created by the government has now multiplied by ten times that in new money in the marketplace, with no corresponding increase in goods or materials.
Did the bank have this money to lend? No, it was created out of thin air through a combination of fractional reserve banking and the government magically turning a debt into an asset. The bank did not have to do anything to earn this money other than push buttons on a computer. Therefore, what justification do they have for charging 5% on the money, created out of thin air, which was not earned by them through their own labor?
Inflation
We discussed in Chapter 2 that the cause for inflation is the creation of paper money out of thin air, not backed by any resources such as gold or oil. Inflation is not caused by growth of the economy; if it were, the corresponding increase in production would cancel out the loss in value of the dollar and the net result would be the same as before. But we all know from experience that inflation has eroded the value of the dollar, which can be easily observed in the increased prices of food, energy, housing, and other goods we purchase that is not equaled by a concurrent increase in our income, known as purchasing power.
When money is created out of thin air and multiplied through the banking system without a concurrent production of new goods, then the prices of all existing goods get more expensive. It is not hard to imagine that, when the amount of available resources are the same and money supply is expanded, the new money in the market bids up prices of the existing resources. This is inflation.
Prior to the Bank of England in the 1800s, governments had limits on how much debt they could issue and subsequent money that they could create.2 However, the concept of the central bank allowed governments to tax their people through inflation without them being fully aware of what was happening. While raising taxes may be politically difficult, taxing people through inflation is easier when the people don’t know how the government and congress create new money out of nothing and use it to dilute the purchasing power of the people.
The modern banking system then taxes the people at the rate of inflation of the money supply, which is ten times the amount of debt. This amount dwarfs the actual amount of tax revenues the IRS receives. Why then does the government just print money whenever they want? What is the purpose of taxes? If the government does not tax the people, the people may begin to wonder where the government gets their money.
Using inflation taxes the middle class to pay for the power of congress and interest profits of banks, without them knowing it.
Other Consequences of Fake Money: Asset Bubbles
Balance of payments is vital to the economic success of our country, but most people don’t comprehend the full value of how the concept affects our overall wealth. This is the total amount of money and assets that are moving into or out of an economy. Balance of payments is important because it measures whether our society is obtaining or losing wealth. It is the cash flow statement for our nation. Not only is it the cash flow statement of what is currently coming in and out, but in our paper money system, it is a harbinger for economic problems caused by excessive money outflows to other nations.
There are two main components of the balance of payments. One is the current account, which is the measure of exports and imports. The other is the capital account, which is the measure of money. These two things need to roughly balance.4
Current Account
The Unites States used to be a net exporting nation. This means that we made goods and sold them to the rest of the world. With our earned income, we could expand our technology, build plants, or increase our general wealth. However, the United States no longer exports more stuff than we import. Since the early 1970s, the United States has been a net importer, buying more from the world than we manufacture.5
One of the reasons our status as an export nation is important is that during the Great Depression, America was able to produce her way out of economic distress. American did take on some debt during that time period, but through growth in production and exports, we paid back our debts while subsequently improving our standard of living. Because we are now a net importer of goods, America does not have the ability to produce and export our way out of our debt troubles.6
In any scenario, our ability to consume is limited by our ability to produce and sell goods to pay for the consumption. With the central bank structure, we are no longer limited to consuming in equal amounts of what we produce. We can consume as much as we want, as long as we can convince the rest of the world to buy our debt with the money we create.
This is why we rely on increasing levels of debt expansion and money printing to gloss over our existing cash flow issues and prevent an economic collapse. The collapse is inevitable given the path we are on. It would have been better to sustain the market losses in the short run, learn from our mistakes, institute sound monetary policy, and move forward with true economic expansion in mind. But we have not done this.
Capital Account
The other part of the equation is the capital account. It measures the money flows from country to country. When a country, such as Japan, exports more than they import, they receive a lot of currency in exchange. That currency will then be placed in some investment that is expected to earn a rate of return. When a country imports more than it exports, that country’s currency gets exported, in exchanged for the imported goods, to other countries.
This is where the equation becomes interesting. When a country, such as Japan or China, has extra money from all of their sold goods, they need to put it somewhere to earn a return. Those extra dollars have traditionally come back to the United States in two forms of investment. If China sold the dollars and redeemed them for Yuan, it would create a surplus of dollars and a shortage of Yuan, making the value of the dollar fall and the Yuan rise. A rising Yuan and falling dollar would reduce Chinese exports to the United States, which is the last thing that China wants. The US is the largest economy with many assets and a government that has put its “full faith” behind our debt issues. Therefore, China will take US dollars and buy US debt with them.
Japan will also buy US debt to keep their currency from rising. When the US issues a bond, the money that the citizens used to buy stuff, say from Japan, is then recycled back to the US to buy this bond. The Japanese, now holding this bond, expect to earn interest on it. The bond issuer, which can be a government or a company, now has a liability they have to pay back later in exchange for cash today.
The cause of the massive rise in American public debt has roots in the US being an importer nation. The money we send overseas returns to us in the form of purchases of our government debt issues, as seen in Chapter 3. Because the US guarantees debt with the full faith and credit of the US government, which nobody expects to fail, it is very easy for our government to sell more and more debt over time.7
As we explained with fractional reserve banking in earlier chapters, money that comes into US banks is re-lent at a ratio of nine-to-one. When the money that US consumers spend on Japanese stuff (exports) comes back into the US as investment, it eventually works its way into the banking system and is multiplied by the nine-to-one factor. This process repeats many times, building up the supply of dollars.2 Why does this matter in the discussion of booms and busts?
This money was created by our bank, often due to fractional reserve banking. That same dollar has travelled across the world to buy a good, and then back again as investment from another country. That dollar, itself a bill created out of thin air in fractional reserve banking, is then subsequently multiplied AGAIN through fractional reserve banking. Voila! We have taken an original deposit, multiplied it, spent it, saw it come back to us, and then multiplied it again.
When billions or trillions of dollars are circulated throughout the world economy this way, they multiply at an increasing velocity.8 This speeds up the process of inflation, where the dollar you had yesterday just bought you less stuff today, through no fault of your own. The banking system, designed to create stability in our economy, actually creates instability through rampant money creation, which leads to the inflation of prices.
Remember there is another way in which countries will invest in the United States. Instead of buying a bond or debt instrument, Japan could invest in real estate or the stock market. This seems like a good thing to the US. That money invested can be used to support these markets. The problem is, because we are dealing with billions and trillions of dollars as a result of all of our purchases of foreign goods, these markets don’t only get supported- they get launched into the stratosphere.
The reason why the United States had a real estate bubble which crashed and then melted away a large portion of American wealth was due to excess money creation seeking out returns through real estate. This time, the money was created in Asia as Japan tried to lift itself out of its own decades-long recession. Japan printed billions and purchased US Treasuries, which lifted the US out of recession and caused US interest rates to fall. Banks began to lend.
The increased money supply sought out profitable returns in the marketplace.8 Contrary to what Keynes said in his economic theory, countries don’t like to hold hordes of cash which will devalue over time due to inflation.6 They will eagerly seek out the best return on investment.
This process creates asset bubbles, the same process which created the asset bubble of technology stocks that crashed in 2000. The influx of investment to the stock market both by foreign entities and by the increasing American contributions and matches into their 401K plans inflated the stock market into a bubble. While the technology companies saw their stock rise to historic heights, their balance sheets in many cases did not show have any positive earnings! But the sheer amount of paper money in the market sought out positive returns, and therefore fed the stock market bubble to unprecedented levels.
If we relied on a true gold standard and were not able to print fake money based upon debt that the government never expects to pay back, then we would not have asset bubbles of the magnitude we see today. Limited money promotes consistent values in stock markets and real estate. Values would not balloon if there were not excessive fake money in the system, and therefore would not crash once the money supply grew too large to be supported by further debt issuance. Home values and stock values would be based upon the utility they give to the holder, not upon an arbitrary value driven by whatever amount of currency the government decides to inject into the market. Government manipulation of currency clouds true prices so that at any point in time, the buyer and seller are not sure what the true price is and whether they will take a loss or gain in the future. Therefore, real estate and stock markets are largely speculative with more inherent risk baked into each price level. They are prone to booms and busts, over and over again, as the government further manipulates the fake money supply.
The Housing Bubble is Not Over
We have seen a correction in real estate prices in the last few years, and many of the main stream media seem to think that housing prices have stabilized. However, real estate will devalue again. In 2010 and 2011, the rates on Alt-A loans will reset to adjustable and a new wave of mortgage defaults is coming. The Alt-A mortgage market is larger than the subprime market which caused the original meltdown.
The result of the subprime meltdown occurred when Mortgage Backed Securities (MBS) that were packaged by banks and sold to investors began to default. Banks, because of the lower interest rates resulting from the influx of Asian capital and lowering of US interest rates, began to lend out more and more money. They relaxed their lending standards and lent mortgage money to anyone who could sign a piece of paper.
In many cases, they did not even require documentation proving the borrower’s qualifications. These loans were dubbed “Ninja” – no income no job – loans. These loans were often indexed to the volatile LIBOR interest index, with a short fixed rate teaser followed by an adjustable rate. When the fixed rate period, often only one year, lapses, the adjustable rates increased the mortgage payments due and people were not able to make their new payments. These loans began to default and the MBS began to fail.
MBS are part of what is called the derivatives market. Derivatives are investments whose price and value are based upon the assets they are written on. When the underlying assets, such as MBS, fail, it causes a chain reaction. When a derivative contract is about to expire, often a new derivative is placed on top involving new investors. This daisy chain of investments often covers up the fact that the underlying assets are very risky. And each additional link in the chain separates the investor further from the original issuer. If that issuer is bankrupt and cannot pay, then the whole chain fails. There is no way of knowing who is on the other end of the chain.
The derivatives market is currently not regulated like other financial markets and transactions are often privately conducted. It is estimated that the derivatives market is a quadrillion dollars large. A failure in this market would be significant enough to take down the global financial system.
How Asset Bubbles Hurt the Middle Class
The excess money causes volatility in our markets at home in the same markets where the middle class stores their wealth. As we noted in our introductory chapter, up and down volatility in the markets makes it very hard to earn a steady positive return. Dollar cost averaging was conceptualized to explain how investment in a turbulent market can be good. But most discussion of dollar cost averaging does not discuss the flip side of the coin – how volatile markets can steal wealth from automatic investing and move it to savvy investors who play the market movements more astutely. These savvy investors don’t have automatic investment contributions and therefore can long or short the market as they see fit against the public, without participation in the downtrends.
Americans also invest in their homes, which is their single largest “investment.” When these markets rise too fast due to excess paper money investment, they will always come crashing back down.
Because no new goods are created in fractional reserve banking, the prices of goods that the middle class buys rise. As the asset bubbles crash the value of the investments we store our money in, this double whammy destroys a lot of American wealth.
In fact, most of the wealth has moved from the poor and middle class to the wealthy, who tend to sell assets that are inflated and then buy them back when they are cheap. The middle class does just the opposite. They buy the assets on the way up, don’t understand when to sell, and lose their money as the asset crashes. The mortgage crisis that started in 2007 moved a lot of wealth from the middle class to the rich. This explains why, in Chapter 1, the middle class is eroding. We pay more for education and products through inflation and lose value in our long term investments.
Compensation for financiers is rising faster than that of the average American salary. Between WWII and the early 1980s, financial sector compensation averages were very close to other industries. After 1982, this began to change. The average financial sector salary peaked at 181% of all American private industries in 2007, the same year the mortgage crisis began to take shape.9
We can further examine the concentration of wealth to the financial elite by looking at income data from a Goldman Sachs 2007 annual report.
Goldman Sachs had 30,522 employees, with average compensation of $661,490 per employee. While Goldman Sachs may not be indicative of all financial sector firms, it serves as a stunning example of the concentration of wealth among a smaller and smaller group in the financial sector.
The second way in which our banking system creates instability is through asset bubbles, which take the savings of the American middle class and gives it to the elite.
Asset Bubbles are Global
The US is not the only country to experience the asset bubble problem. This problem was rampant in Asia as US Dollars went overseas seeking high rates of interest. This caused the Asian markets crisis of the 1990s.8
Japan is in a decades-long cycle of no growth. Instead of devaluing their currency, they have pegged interest rates near zero and have tried to ride out the economic cycle, avoiding a crash. In addition to low interest rates, they have issued a lot of debt to bolster the demand side of the economic equation. Japan currently has debt equaling 214% of GDP.10
Japan relies on a cheap currency to lower the price of their goods. When their goods are cheap, more are bought which boosts income. Because the world is in a credit and debt crisis, lowering the value of Japan’s currency makes goods attractive, but not more affordable. People, including Japan’s major importers- the US and China- cannot afford to buy the goods.
Therefore, Japan seems to have run out of policy options. They cannot reduce their interest rate any more to make the currency cheap. They are about maxed out on debt issuance, so they cannot boost demand for goods by the government sector to make up for lack of worldwide demand. Unless China and the US can rescue its economy, Japan might the first economy to slide into depression. Japan would be the largest economy to do so in current times. That is, until the United States suffers the same fate.
It is important to note here that the concept of a central bank is used internationally. Many works have been written on the motives and methods of the international banking community. Suffice it to say that taxation through inflation is rampant among world nations and it puts the world communities on a collision course with middle class wealth depletion. In one way, international banks and governments collude to destroy middle class wealth. In another way, when the middle class cannot support the gluttony of the banks and governments, crashes ensue. In many cases, these economic crashes lead to wars.2
What is apparent even to the casual observer is that fiat money from a reserve currency nation, such as the US, distorts market prices through inflation and creates dangerous bubbles and busts in world economies as the money floats back and forth between them. This problem is not limited to the United States and as countries teeter on the edge of default, the US will be asked to step in and solve the insolvent economy’s problem.11 Because this is done through further money printing and debt issuance, the problems work their way back to the United States to continually rot out the foundation of our financial systems. At some point, the house of cards collapses, at which time the world will be plunged into another economic depression.
Why the Gold Standard Worked
Now that we have an understanding of why economic booms and
busts happen and how they can negatively affect the poor and middle classes, we can examine why the booms and busts before the use of paper money were not as destructive. It stands to reason that if we apply the controlled approach used pre-Federal Reserve, we will reduce our exposure to destructive boom and bust periods that we have been experiencing with increasing frequency in the last 100 years.
The booms and busts that the American economy used to experience were not as exaggerated as they are now. Before we had a central bank that could print as much money as it wanted, America used gold as its currency. The mere thought of using gold now is often laughed at. Gold is seen as jewelry and not money. Most people would argue that there is not enough gold and the economy would not work if we had to carry around bags of coins. It is easier to use paper money, isn’t it?
There are several reasons why this isn’t true. Before America had a central bank, called the Federal Reserve, it is true that the economy operated in booms and bust cycles. But the scope of those booms and busts were smaller than they are now with paper money in circulation.2
Economies had more discipline on the gold standard that was used before WWII. Countries were forced to budget their expenditures.6 When a country lacked adequate gold reserves, it could not wage expensive wars without borrowing. Because it had to borrow, there was always a cost to war. Now, the US prints paper money to pay for its wars, and asks the middle class to pay it back in the form of price inflation and increased debt. Because it is easier to wage wars, the wars have gotten much more expensive for the public to pay for. That alone is a good reason to use a reasonably limited monetary system.
It is not true that we need to have an expanding supply of money for an expanding economy. When the economy expands with a limited money supply, the result is falling prices which benefit the poor and middle classes. What we have now is the opposite: an expanding money supply which creates inflation which reduces what a dollar will pay for.6