The Federal Reserve: Money, Debt, and Inflation

The Federal Reserve Bank of Philadelphia lobby...

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In my last post, I gave a brief overview of the Federal Reserve’s process of money creation.  In short, money is created with nothing (gold or goods) bolstering its value.  In addition, fractional reserve banking allows the creation of roughly 9-10 times the amount of printed money via electronic entry into the Fed’s balance sheet.  What results in nothing much different from Monopoly (fiat) money, except that this practice is allowed by the American people’s tacit consent.  What I did not discuss is the impact that printing money has on the average consumer and taxpayer.  It is to this that I now turn.

Money Creation Leads to Debt Creation

It is important to remember that before money actually enters the economy (circulation), it is not part of the money supply.  Until money is spent, it does not affect prices and therefore cannot yet be a part of the money supply.  So the next question to ask is how does money enter the economy.  The answer is debt.  For money to enter circulation, it must first be borrowed from the central bank at a given interest rate, termed the discount rate.  Let us say the discount rate is 2%. That means large banks like Chase Manhattan or Wells Fargo, when borrowing from their regional Federal Reserve bank pay a 2% rate on that money. This allows room for those banks to do a mark-up.  They loan that money at higher interest rates, the difference between the two rates being their margin or profit.  However, something is missing from this picture.

If I want to borrow money, I must go to the bank and put up some form of collateral whether it be my house, car, or investment equity.  So I must put up something of actual value in return for money created out of thin air with no real assets backing its value.  This is not a fair market exchange.  If I default on my loan, the bank may confiscate my collateral.  However, a legal contractual agreement requires both parties to put up some form of collateral in the deal, but the bank does no such thing because the money they loan out fails to mirror any form of wealth creation as when a good is produced and sold such as a car, or a given amount of gold is mined and brought to mint.  That money has no real value except by government declaration.  Here we see that the fraudulent nature of our entire monetary system is grounded in the very subtle act of creating fiat money and using it to create debt.  Debt creation, then, becomes the primary impetus for our nation’s money supply.

Debt Creation Leads to Inflation

There is more however.  Keep in mind that the value of money, typically termed as the value of the dollar, is determined largely by how many dollars are available (supply).  As the law of demand dictates, the more of something that is available, the less that commodity will bring at market.  In other words, the more money put into circulation, the less valuable each dollar becomes and the less it will purchase.  This is inflation and results in what we know as a decrease in real income or a decrease in purchasing power.  We are lead to believe that inflation is a natural phenomenon, but in reality it is a manufactured product of our monetary system.  Inflation occurs when our money supply increases at a greater rate than the production of goods and services on which to spend such money.

To illustrate this, I will use a simple thought experiment.  Suppose instead of stimulus spending, the government simply printed enough money to write each household in America a one million dollar check.  This would certainly stimulate spending, as everyone would suddenly have much more purchasing power.  Demand for goods would increase greatly, spurring job growth and economic prosperity in general.  However, such gains would be only temporary because that additional money would push prices up until the market demand adjusted to the new supply of money.  This is best illustrated if we simplify our market.  Let us assume our market consists of only two people and they are buying bread. Let us say that each person has $10 to spend.  The supply of bread is determined by how much each person is willing and able to pay.  If they are only willing to pay $.50, the market will supply 40 loaves of bread. However, if they are willing to spend $10, the market will supply only 2 loaves.  How much each is willing and able to spend is their demand. And as the supply of money increases, so too does each consumer’s willingness and ability to pay a higher price.   If those two people suddenly have twice as much money to spend on bread, the end result would be prices twice as high with no more purchasing power for the consumer.  Thus, we see the concept of inflation manifested as a natural product of an increase in the money supply without a like increase in goods and services.

Money Creation Leads to Inflation

As if this is not shocking enough, the story is not over.  What results is a double whammy for the average consumer and taxpayer.  My argument above is as follows:

P1: Money creation leads to debt creation.

P2: Debt creation leads to inflation.

C1: Therefore, money creation leads to inflation.

The implications of this are staggering.  Not only does our monetary system utilize the mechanism of fraudulent debt obligations to the Federal Reserve Bank by the public, but the consequence is perpetual inflationary pressures.  The data below looks at the trends between the rate of inflation since 1957 as measured by the chained Consumer Price Index for all urban consumers (C-CPI-U) and the rate of growth in the total money supply (TMS).

There are different measures economists and bankers use to monitor the money supply.  The most basic is M1, which includes all cash held by the public plus demand deposits.  The TMS accounts for the following: all cash currency and public demand deposits, government demand deposits and note balances, and demand deposits from foreign governments and private institutions.

Inflation then, acts as a hidden taxation via the erosion of consumer purchasing power, while debt acts as a hook by which the borrower must put up real wealth for fiat money.  Moreover, imprudent government spending on bailouts, stimulus, and earmarks increases the future burden of taxation by states and the federal government.  This practice is known by Keynesian economists as deficit spending and was largely a product of the Great Depression.  What is clear is that creating money for deficit spending devalues the dollar and damages the solvency of the U.S. government because government, as well as private, debt perpetuates inflationary pressures on the dollar.  What we have here is a great potential for future insolvency.  Think what might happen if developing countries like China decided to cash in all their U.S. Treasury securities in fear of the declining value of the dollar.  Given that China owns a significant portion of the American debt obligation, such an act would devastate our economy as trillions of dollars would flood our markets in an attempt to convert them to tangible assets (goods that represent real wealth), plummeting the value of the dollar further and resulting in massive and rapid inflation.  This is just one scenario scholars and our more prudent politicians have examined.

The only solution to this predicament is the absolute abolition of the Federal Reserve Bank and reinstatement of the gold standard.  Only a gold standard can provide the base valuation of a currency.  Without a base by which to regulate the monetary unit, its value can and will be manipulated.  Our Federal Reserve Act of 1913 was not the first.  Believe it or not, a national bank has been tried before in America more than once, and each time it failed due to massive devaluation of the monetary unit.  Again, the only aspect of our monetary system that keeps it in place is the tacit consent of the people to keep playing by and paying for these fraudulent rules.