Mo' Money, Mo' Problems

(I wrote this article in December of 2008. It was originally posted on my facebook)

Around the beginning of November this year, I read an article by John C. Medaille regarding a recent article by Pat Buchanan. This quote piqued my interest: “In truth, the federal budget is mainly about transferring wealth. However, it is largely a transfer of wealth from the bottom and the middle to the top.” I read his examples, but I also considered that there may be more to this idea.

Fast forward to last week. I was trawling YouTube and came across a video of Ron Paul on the news. He was talking about the Federal Reserve and gold-backed money. I was struck by his speeches and considered what he said in light of things I have learned in classes I've had recently. I remember especially a class on the monetary system we have. What follows is a synthesis of my basic learnings and thoughts on the topic. Feel free to comment, but please be respectful, I'm not a Ph.D.

The value and amount of our money in circulation is controlled by an institution called the Federal Reserve. It regulates the banking industry and influences its activity by buying and selling securities and by reducing or increasing the amount of money that banks are required to hold on reserve. (1) These changes alter the interest rate at which banks can borrow from the Federal Reserve (called the discount rate) and the rate at which banks borrow reserves from each other (called the Federal Funds rate). There are basically two ways this can go. Either the rate is lowered via a buying of the securities or the rate is increased via a selling of the securities. Lately, the rate has been low. In 2001, after the terrorist attacks, the rate was lowered extremely and kept low, creating a lot of money. More recently, the rate has been lowered again to about the same level (it came up in between those times). One of the effects of this low rate is inflation. Inflation is, “the rate at which the general level for prices of goods and services is rising, and, subsequently, purchasing power is falling.” (2)

So, what's the problem with inflation? We hear about it all the time on the news, but what does it mean to you and I?
Firstly, inflation erodes wealth. As the definition given above states, purchasing power falls. The dollar you have today will be worth less tomorrow. Two things are to be noted here. When the dollar is inflated, things get more expensive. A loaf of bread now costs more than a loaf of bread 10 years ago because the value of the thing that you exchange for it has dropped. Also, the value of your savings drops. Any money you have invested in a retirement account is basically taken from you in increments because its value is decreasing. When you put that money away in your 30s, it was worth X amount of bread or milk. Later, in your 70s when you draw that money out, it buys X minus some factor of inflation amount of bread or milk. As the currency inflates, people become poorer. This increases the number of people who are poor, as their wage doesn't really change in proportion to this inflation, especially when the inflation is as rampant as it has been. These people are forced to spend greater amounts of their money on sustenance and less on saving and other things. Meanwhile, the government benefits from this increased amount of money. By simply printing money the government can carry out its programs that increase people's dependence on the government and can finance wars and whatever special interest it may have. In this way, Federal Reserve-created inflation acts as a secret tax on the people. Sure, you may not actually file an IRS return to the Federal Reserve, but the government certainly is taking your money. Large businesses are also favorably impacted because they benefit from the low interest rates. They use credit to grow and increase the wealth of their shareholders. While this happens, the so-called “middle class” is eroded as the money moves from their pockets to the pockets of government officials and the wealthy. The middle class becomes poor.

Secondly, inflation creates business cycles. The banking system as it is now is based on fractional reserves. This system dictates that “only a fraction of bank deposits are backed by actual cash-on-hand and are available for withdrawal.” (3) This creates a reverse pyramid of credit. One bank who gets the newly-printed money from their friendly Fed bank makes loans with that money. Not only do they make loans equal to that money, but they may only be required to hold 10 or 20 percent of it in reserve. Now, that money moves on to the next bank where it is deposited and the same thing happens again. This creates an effect known as the multiplier effect. (4) How does this create business cycles? Businesses that rely on credit to operate (a great many of them, in my experience) depend on this multiplication of money. They borrow the money to grow the company and create wealth for the shareholders or owners. This creates a boom. Now, two things, in my mind, contribute to the subsequent recession. One, the inflation created by this newly-printed money increases the prices of the companies' inputs. This causes the businesses to cut production to save money and results in a contraction of the economy (also called a recession, in some instances). Two, the Federal Reserve may decrease the amount of money in the economy (which increases the rates) and the credit that the companies rely on becomes more expensive. In the same way as before, the companies' costs increase and they are forced to cut production to cut costs in order to survive. This also causes a contraction in the economy.

So, what does the Federal Reserve do about all this? They attempt to manipulate the inflation using their power to alter reserve requirements and the money supply. However, the attempt to flatten these booms and recessions simply doesn't work. One notable example is the Great Depression. FDR could have fixed the problem by returning to sound money (money backed by gold or silver), but instead resorted to fiscal policy (i.e. spending his way to prosperity) to “fix” the problem. Sure, people had jobs, but the real specter was the inflationary system that underlies the economy. These people were destined to be poorer because of the vicious circle that had come about. The government needed money to spend on the programs and the inflation that resulted was destined to steal from the workers.



The reality is that this fiat money (money that is not convertible into something that has intrinsic value) favors the government and the large businesses. It is based on a system that steals from the poor in the form of high prices and a loss of wealth and gives to the big daddy federal government and your rich neighbor. Sound money, or money that is convertible directly into something of intrinsic value (such as gold or silver), favors the people. Sound money saves us from this inflation that results from the creation of money from nothing. The inflation is stopped because the supply of money is fixed (i.e. one dollar is equal to a fixed weight of gold). Interest rates are kept low because they fall to the competition between banks instead of relying on the decisions of a handful of men in Washington D.C. In case the moral implications are not obvious enough, consider this: if a farmer dilutes his milk with water and sells it, he is put in jail. Why are these men given free license to do the same with our dollars?