Wednesday, January 13, 2010

Do We Need the Federal Reserve?

I came to all the conclusions in this piece slowly over the years. To do it I had to unlearn and throw off almost all my Keynesian economics training just about the only kind you got back when I was an economics major. I guess the opposite of Keynesian economics would be the Austrian School of economics which until quite recently has been out of favor and ignored. There is a reason for that. It really doesn’t provide a rationale for increasing government power.

"Give me control over a nation's currency and I care not who makes its laws."
- Baron M.A. Rothschild (1744 - 1812)


The first thing we should clear up is the definition of wealth and the difference between money and wealth. Wealth is not the piles of paper, the bits on some magnetic storage device or even coins made of gold or silver. These things are used as money which can be a proxy for wealth as long as it is accepted as a store of value by individuals in a socioeconomic system and more importantly as long as it is not manipulated as implied by the above quote.

Once any such manipulation is truly understood by the actors in an economic system the store of value status is lost. Unless savers and investors have before this loss of value occurs moved to things that directly and more securely represent real wealth they lose everything. People have learned this painful lesson about money many times in the past.

It is important to remember that money is only a medium of exchange and can be a store of value only in a stable viable socioeconomic environment. Ultimately you cannot have a stable socioeconomic environment when the supply of money is manipulated.

Real wealth isn’t a static thing. It is productive capacity. It is a process by which people in an economic system apply brain power to the problem of producing goods and services that other folks want and that make living easier and better, better living through science and entrepreneurship so to speak. Investors can own a stake in this productive process through certificates of ownership via securities like stock or they can own a promise to pay a debt from wealth producers via securities like bonds. They can also hold money at interest which is a broader kind of security. It is the overall accepted store of value by a society and represents but is not actually the wealth of that society.

But as I said above once confidence in the store of value idea for a given type of money is lost your monetary representation of wealth is FUBAR. Fiat money the only kind in existence at this point in history can only hold its store of value status based on the promise by the government issuing it that it is in fact worth its stated face value. Ultimately no fiat money has ever lasted because it is too easily manipulated. Commodities like gold and silver however were more successful because they have intrinsic value and have some use beyond their use as money. Also much more importantly their supply is more limited although governments have debased even these types of monies by adding less valuable metals like lead to produce gold coins for example.

I consider 1913 the year that sealed the ultimate economic fate of the USA. It was the year that the Federal Reserve was created and the federal income tax was permitted by the ratification of the 16th Amendment (a subject for another time). The final nail in the economic coffin was the end of the gold standard for international transactions in 1971. In the U. S. we went off the gold standard internally in 1933 when the federal government confiscated all “monetary” gold and handed gold owning citizens twenty dollars and change and then promptly declared that all the gold then owned by the U. S. government was henceforth to be valued at $35! Not only was the confiscation a direct violation of the Constitution but they immediately cheated each gold owning citizen out of $14 dollars and change! Once upon a time any bill introduced into Congress was almost invariable challenged on grounds of constitutionality as a matter of course. See how easy violation of the Constitution had become by 1933?

Even so there was still some restriction on money creation by the Fed because internationally the dollar was still backed by gold. When that link was broken by Richard Nixon the Fed was freed to create as much money as they pleased whenever they pleased. We then had a pure fiat currency.

Did the Founders understand what printing too much paper money can do and what hyperinflation is? You bet they did. The demise of the paper currency called the Continental dollar was fresh in their minds when they wrote the U. S. Constitution to replace the Articles of Confederation. In point of fact they authorized the federal government to only create hard money from gold and silver. This is authorized in Article I Section 8. It says:

“To coin Money, regulate the Value thereof, and of foreign Coin, and fix the
Standard of Weights and Measures;

To provide for the Punishment of counterfeiting the Securities and current Coin of the United States;”

The Founders had no intention of allowing the unrestricted printing of a paper fiat currency. Under the Constitution there was and still is not any authority to do so or to create a central bank that could do so.

Some of the current increase in the price of gold, silver and other precious metals is due to an actual increase in value or purchasing power if you think of it in terms of money relative to other things. That’s because demand has increased and precious metals are relatively scarce. But most of the increase is because the value of gold and silver stays stable while fiat money is decreasing in value (now primarily internationally) as it is being created by central banks.

For thousands of years, gold and silver have been used as money. That’s because they are relatively scarce and convenient to use compared to other things. Fiat money (our paper and electronic forms) is very convenient but when politicians and bureaucrats have power over its quantity they will always abuse that power at some point and bring instability and a decline in purchasing power to consumers. They get away with it because the “dumb masses” as Boortz likes to call them don’t understand the process.

The “dumb masses” can’t be totally blamed for that since the people in power work mightily to hide the true reasons for inflationary price increases. That is because inflation is a hidden tax. They even spread the canard that a little inflation is a good thing. That’s odd because overall the period between 1800 and 1913 a period of massive industrial expansion had no price inflation. In fact in 1913 the dollar had slightly more purchasing power than in 1800. We have only had stability in purchasing power when we used gold and silver directly as money or to back another form of money like paper. It will always be thus.

There has also been a canard spread through the education system and MSM that falling prices are a bad thing. That is not necessarily the case. If prices fall because of advancements and efficiencies in manufacturing and services, that is actually a good thing. The decline in the cost of electronics is an example. BTW, that decline began long before the current day outsourcing controversy.

There were of course ups and downs in the business cycle during the period 1800 to 1913. But some of that was due to wars especially the massive conflict in the middle of that period. The American Civil War was devastating yet the period that contained it was still a period of amazing economic progress and prosperity. Downturns not connected to war were brief and economic recovery rapid during the period. It was not until the 1930’s that we had a prolonged period of economic problems. The evidence is very strong that these problems were prolonged by government and Fed actions.

I have concluded that unless we return to a gold standard or some other commodity (one of limited supply) based money system we will never be able to rely on our monetary system. I have further concluded that we do not actually need the Federal Reserve. Those banks can be dissolved or just converted to ordinary banks. Think about it. Why do we need an institution that can change the thing we use as a store of value whenever the folks that run it wish or when politicians pressure them to do so? It is nothing more than a hidden tax system. At the very least such power should be restricted. That restriction existed when we were on a gold standard.


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